S&P 500 Index Funds Have Lots of New Competition

This week the SmartMoney Fund Screen takes a look at Bogle's pride and joy, the low-cost, no-frills index funds that give most Americans their exposure to the stock market. In order to do that, though, we had to switch things up a bit. In previous columns we stressed management tenure and a fund's long-term, market-beating performance. That doesn't apply as much to index funds since they don't have active managers and their goal is to simply mirror the returns of a given bogey.

Instead, this time we put a stronger emphasis on expenses. We nixed funds that charged a sales load or an expense ratio over 0.5% a year, two-thirds less than our usual cut-off. After all, since the fund is only going to track an index, a load or excessive fees will guarantee shareholders lose out. Surprisingly, many of them charge too much. We cut 150 funds from our initial list of 172 S&P 500 index offerings because of loads and fees. That list included funds from Gartmore, Wells Fargo, Evergreen, JennisonDryden, BB&T and First American. Their investors should be outraged.

By far the most popular types of index funds that made our list are those built around the S&P 500. Indeed, Standard & Poor's estimates that over $4 trillion is benchmarked to this stock index, which ranks companies according to their market capitalization. In other words, the nation's largest firms take precedence here. The top five positions are Exxon Mobil (XOM), General Electric (GE), Citigroup (C), Bank of America (BAC) and Microsoft (MSFT). In recent years, Fidelity and Vanguard have gotten into a pricing war over the fees charged by their S&P 500 products. If you can pony up $100,000, the two companies will charge you less than 10 basis points a year, some of the cheapest mutual fund fees on the planet.

Even as the S&P stands firmly atop the indexing world there are rumblings that it might not be the best way to play the market after all. Granted, the S&P 500 has always had competition. There's the Wilshire 5000, essentially an index of the entire market. And the Russell 3000, 2000 and 1000 indexes that are popular with investors who specialize in value, growth and smaller-sized stocks. Morgan Stanley Capital International's U.S. Broad Market index serves as the benchmark for the $37 billion Vanguard Total Stock fund (VTSMX), which has beaten the S&P 500 over the trailing three-, five- and 10-year periods, according to Morningstar. Its fees start at 0.18% and drop according to how much you invest.

But the more heated battle for index supremacy is coming from the exchange-traded fund world. ETFs are just like index funds — similar fees and companies — but they trade throughout the day on an exchange. They also can be shorted. In an effort to distinguish themselves in a crowded marketplace, some ETF providers like PowerShares and Rydex have embraced newfangled indexes that either weight the S&P 500 differently or create a whole new index. These new products, their sponsors contend, will give investors better returns with less risk.

How can they do that when they are all essentially investing in the same companies? Good question. The short answer is that it all comes down to weightings.

Actually, it isn't quite that simple. The S&P 500 uses market capitalization (stock price times the number of outstanding shares) for its weightings. But that can cause a problem during bull markets. Overexcited investors can push up a stock well beyond its legitimate value. Indexers like Bogle say that's just a natural part of investing. The ETF crowd counters that it fills the index with overvalued companies that are bound to implode. They instantly point to the tech bust as evidence.

To counter that phenomenon Rydex created its S&P Equal Weight fund (RSP). The idea here is that by giving the same weighting to each member it will prevent a red-hot stock or two from affecting performance either on the way up or, more importantly, on the inevitable slide down. "It eliminates any bias [toward certain stocks]," says Rydex's Tim Meyer. The PowerShares FTSE RAFI US 1000 (PRF) uses a "fundamental" index designed by Rob Arnott, the founder of Research Affiliates. Arnott uses revenues, cash flows, dividends and book value, among other metrics, to calculate his weightings.

The top 25 holdings of both funds look pretty similar to the S&P 500, except that the two ETFs have slightly different percentages in each holding. For example, the S&P 500 has 3.5% of its assets in Exxon. The PowerShares ETF has 3%. That doesn't sound like a big difference. But those subtle overweightings add up. Indeed, the Rydex Equal Weight fund has returned an average annual 14% over the last three years, almost three percentage points better than the S&P 500. The Powershares ETF has only been on the market for about a year but it too is beating that benchmark by three percentage points.

Now, that could be, in part, because these funds have more exposure than the S&P 500 to value and small-company stocks. "Arnott's solution successfully removes volatile and potentially misleading stock prices from the equation," wrote Morningstar's Karen Dolan in a recent write-up on the fund. "But in doing so it introduces some other biases. The index has a value tilt and ends up placing more emphasis on stocks with smaller market caps." Arnott, of course, has a problem with that synopsis. "Everyone says the index has a size effect or a value effect," he says, with a tinge of sarcasm. But, he says, the results are finally showing in his favor. Now he just needs another year or two.