Since the number of funds we can cover in-depth is smaller than the number of funds worthy of in-depth coverage, we’ve decided to offer one or two managers each month the opportunity to make a 200 word pitch to you. That’s about the number of words a slightly-manic elevator companion could share in a minute and a half. In each case, I’ve promised to offer a quick capsule of the fund and a link back to the fund’s site. Other than that, they’ve got 200 words and precisely as much of your time and attention as you’re willing to share. These aren’t endorsements; they’re opportunities to learn more.
INDEX, the fund, and Index Funds, the company, are the product of 20 years of failing to beat the S&P 500. Michael Willis worked for years as an active manager, most recently as a Senior Vice President at UBS Financial, trying to beat the S&P 500. Despite consistent, concerted effort, he couldn’t consistently achieve that goal.
Mr. Willis ultimately reached two sets of conclusions.
First, the S&P 500 contains intrinsic strengths that make it nearly impossible to beat. Its constituent firms are generally pretty solid. It buys and holds. It doesn’t get distracted. And it’s cheap.
Second, the S&P 500 contains intrinsic weaknesses that make it possible to beat. The weighting of any stock in the index is dependent on its market capitalization; the greater a stock’s market cap, the larger its position in the index. And a stock’s market cap reflects the madness of crowds. Market cap-weighted indexes are driven by, and are drivers of, the market’s momentum. Investors get excited about the newest iSomething from Apple (AAPL) and rush to snatch up its stock. The price goes up and passive indexes allocate more of their money to the stock, which causes the price to go up. Because the attention of crowds is limited, they tend to bid up a relatively limited set of stocks which means that the index becomes more and more concentrated in those few. The inadvertent result is that the index has biases toward growth, large caps, concentration and momentum. Those are not universally desirable qualities.
Mr. Willis became intrigued by an alternative approach: investing in the same 500 stocks but weighting your investment equally, rather than weighting it based on a stock’s market cap. In such a system, Apple would constitute 0.2% of the fund, the same as Diamond Offshore Drilling (DO). The FANG stocks, whose collective weighting in the S&P 500 doubled from 3% in 2013 to 6% in 2015, would remain a consistent 0.8% in the equal-weight index. That gives an equal-weight version of the index three distinctive characteristics:
- The equal-weight S&P 500 is more value-conscious. In its quarterly rebalancing, it automatically sells whatever has been bid up and buys more of whatever has been left behind. Currently, the equal-weigh index is cheaper than its sibling whether measured by lower price/earnings, price/sales, price/book or price/cash flow.
- The equal-weight S&P 500 has more exposure to mid-cap stocks. The average market cap of the equal-weight 500 is $20 billion, about one-quarter of the market cap of the cap-weighted version. Neither version offers meaningful exposure to small cap stocks (about 2% in the equal weight version and 0.15% in the other) but the equal-weight version offers vastly greater exposure to mid-cap stocks (47% versus 13%).
- The equal-weight S&P 500 is less prone to inadvertent concentration. If a sector or stock becomes popular, its weight in the cap weighted index automatically grows even if its business prospects or fundamental attractiveness do not. Currently, for example, the cap-weighted S&P 500 has a 50% greater weighting in tech (18% versus 12%) than does the equal-weight version.
In the long-term, biases toward value, smallness and diversification pay off handsomely. One attempt to calculate the returns of the equal-weight and cap-weight versions of the S&P 500 back to 1926 estimate that the equal-weight version returns outperforms the cap weighted version by 281 basis points – that is 2.8% – per year. Over the study’s 90 year horizon, that compounded into a ten-fold difference in returns in favor of the equal-weight index. Standard and Poor’s own researchers place the advantage around 180 basis points per year. The performance of the oldest extant equal-weight index fund (Invesco Equally-Weighted S&P 500 Fund VADAX) shows a 190 basis point advantage over 15 years.
Skeptics of the approach, including our colleague Sam Lee, point out that “there’s no such thing as a free lunch.” The higher returns come at the price of higher volatility, higher taxes as a result of more frequent portfolio rebalancing and the prospect of lagging badly during periods where mega-caps soar. All of which is true, though the magnitude of those downsides seem manageable.
Here, in any case, are Michael Willis’s 300 (admittedly somewhat overwrought) words on why his INDEX fund deserves your attention:
Why buy INDEX over the other guys?
We created a Fund and gave it a profoundly simple ticker to give every investor our story in one word, INDEX.
We created INDEX because we see a trillion-dollar tsunami coming. A wave of RIAs and investors just like us (and Warren Buffett) who realize the S&P 500 Index is an investment best to own rather than to fight.
We created INDEX because we discovered that the best way to beat the S&P500 Index is to own it, equally.
We created INDEX because we believe the equal-weight methodology corrects an intrinsic “buy-high-sell-low” trading flaw imbedded in the market-cap methodology.
We created INDEX because we want to help people get in on the ground floor of the next Wall Street before everyone else does.
We created INDEX because we see the entire investment process transitioning into a simple, performance-driven, low-cost model.
We created INDEX because we see a global realignment coming and believe a flight to quality is only in its early stages and that the constituents of the S&P 500 Index will be big benefactors.
We created INDEX as a no-load mutual fund instead of an ETF because we believe most investors are not day traders nor do they want their nest eggs more vulnerable to intraday algorithms and short sellers.
We created INDEX because we envision a day when low cost investing and transparency reigns on Wall Street.
We created INDEX because we want to create a Mutual Fund Company that grows organically from the investor up, instead of backed by the institutions of Wall Street.
We are headquartered in Colorado because sometimes the crisp clean air of the Rocky Mountains can give you clarity you cannot get in the city.
If you share our values, then we invite you to join our story and help us change the way Wall Street invests.
The minimum initial investment in INDEX is $1,000 and the expense ratio is 30 basis points. From the outset, Mr. Willis has made it a priority to remain one of the lowest cost options of this equal-weight strategy. The fund’s website is organized around a long scrolling homepage, with links to a half dozen articles on their “In the News” page.
