Ignore John Bogle???

I was reading this Marketwatch piece this morning, and find the topic quite interesting. There is plenty of opinion out there that equal-weighted indices outperform market cap-weighted indices.  And when you look at RSP versus SPY, you indeed see the result.

Why would you choose RSP over SPY?

  1. Why index? The conventional reason folks choose stock indices (especially broad-market indices, such as SPY) is to diversify away specific company risk.  We know that holding equity should pay a return in the long run; we just don’t want to get unlucky choosing a bad equity.  So we invest in everything, looking to average returns.  RSP, by investing equal amounts in each of the S&P 500 constituents, has more diversification than SPY.
  2. What about rebalancing? The recent article by Campbell Harvey et al. is instructive here.  It turns out that regular rebalancing increases risk versus keeping a static portfolio.  So perhaps RSP pays more than SPY because it’s taking the extra risk.  Indeed, this is reflected by RSP’s 1.11 beta versus SPY: the former takes roughly 11% more risk than the same $ investment in SPY.  At least for the past year, the return of RSP has been about 1.11x SPY, so I guess the risk/return level is about commensurate.  Anyway, I could just suggest buying more SPY than buying RSP.
  3. What about momentum? See the same article.  SPY, like other market cap-weighted indices, implicitly take a momentum approach to the market. Because there is no rebalancing in SPY, the fund will automatically allocate more capital to stocks with higher returns (and thus higher market cap).  Given momentum is a lasting source of return, you’re essentially getting a trading strategy for free in choosing SPY over RSP.

So what to choose? If capital were no issue, I’d probably just buy more SPY than going smaller in RSP.  I like the lower management fees (yes, I do agree with John/Jack Bogle on that point), and appreciate the implied momentum returns of SPY.  If capital were an issue, I’d think of RSP like IWM: a way to achieve higher returns for the capital than SPY, mainly due to overweighting smaller companies.


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