Can This Simple Strategy Beat the S&P 500?

It's hard for investors to complain about the strong results that the S&P 500 has produced in recent years. Gains of more than 25% in 2013 have added to the market's huge advance since the market's bottom in early 2009. But for those seeking to do even better than the S&P 500, one simple strategy has hidden in plain sight for even inexperienced investors to follow.

Looking past the biggest stocks
To see this strategy, you have to look beyond the S&P 500 as a whole and divide it into component parts. The megacap S&P 100 Index is even more exclusive than its sister index, with 100 of the biggest companies constituting the narrower S&P 100. But when you compare its results to the broader S&P 500's returns, you find that historically, the megacap index has underperformed its more inclusive sibling.

What that means is that the 400 smaller stocks within the S&P 500 have done better on average than the 100 leading companies. That might seem counterintuitive, but it's consistent with studies of small-cap and mid-cap stocks that don't even qualify for membership in the S&P 500. What the results appear to prove is that once companies reach a certain size, it becomes much harder for them to grow further, leading to subdued returns compared to smaller companies with more room left to grow.

How to take advantage
So if you think this strategy is likely to work in the future, what's the best way to implement it? There are a couple of ways involving exchange-traded funds that can help you exploit this tendency if it continues into the future. One is to use equal-weighted index ETFs that own S&P 500 stocks. The Guggenheim S&P 500 Equal-Weight ETF owns every S&P 500 stock just like a regular S&P-tracking ETF. But as its name suggests, rather than owning those stocks in proportion to their market capitalizations, the Guggenheim ETF simply buys equal amounts of all 500 stocks. Because the ETF owns proportionally more of the smaller stocks in the S&P 500 than SPDR S&P 500 ETF or similar index funds, it has outperformed market-cap-weighted S&P ETFs by almost two percentage points annually over the past decade.

The other way you can take advantage of better performance from smaller stocks is to ignore the large-cap S&P 500 entirely and focus on small- and mid-cap stocks. For instance, the SPDR S&P Midcap 400 ETF owns the 400 stocks in the S&P's mid-cap stock benchmark, and it too has beaten the S&P by about two percentage points annually.

It's important to keep in mind that over shorter periods of time, the biggest megacap stocks have sometimes outperformed their smaller counterparts. So don't expect this strategy always to work over the course of a few months or even a year or two. But for long-term investors, using a strategy that emphasizes lesser-known companies can pay off in better returns.

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