The Easiest Way to Exploit the Market

Matthew Carr By Matthew Carr, Emerging Trends Strategist

Market Trends

Here’s something a lot of investors don’t understand…

The markets are flawed.

It’s as simple as that.

Now, I’m not saying the markets are rigged or that investing in them is akin to gambling.

It’s just that all the major indexes suffer from the same systemic problem. It’s a problem as old as the markets themselves. And, for decades, it has spawned a series of debates over how a portfolio should be structured.

I’ll explain more in a moment… but your portfolio shouldn’t be structured like an index. It should be clean and concise. And you have to avoid the mistakes so many investors make.

Everything Isn’t as It Seems

The Dow Jones Industrial Index is made up of 30 companies.

Sometimes investors forget this fact or simply choose to ignore it.

But it’s an important aspect to keep in mind. Especially since all the companies aren’t considered equal.

For instance, last week, the Dow struggled as financial companies like Bank of America (NYSE: BAC), JPMorgan Chase (NYSE: JPM) and Goldman Sachs (NYSE: GS) reported earnings.

JPMorgan and Goldman Sachs are Dow components.

In fact, Goldman Sachs is one of its largest components, accounting for 6.50% of the index’s weight. Visa (NYSE: V) is the largest at 9.35% of the total weight.

That’s a lot riding on financial companies.

Meanwhile, Apple (Nasdaq: AAPL), Exxon Mobil (NYSE: XOM) and Microsoft (Nasdaq: MSFT) are the largest components on the S&P 500.

The Nasdaq is heavily dependent on the performance of Apple, its largest component.

All of these indexes are market cap-weighted.

And this approach has a serious drawback.

As a component company’s share price increases, the index becomes more heavily invested in that company and it makes up more and more of the index’s weight.

This means that the indexes are constantly rebalancing to increase their exposure to companies that are sometimes overvalued.

It also means a single company can have a serious impact on the overall performance of the markets themselves.

We know wherever Apple is going, that’s likely where the S&P 500 and Nasdaq are going. And there used to be an old adage that wherever “Big Blue,” IBM (NYSE: IBM), was headed, that’s where the blue chips on the Dow were going.

Because the indexes are market cap-weighted – more importance is given to larger companies – it doesn’t give you the truest picture of what’s actually happening. You have to view how the components are performing each day to truly understand what’s unfolding.

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For example, if the largest components are down, but everything else is up, it’s an individual company or sector problem.

Because of this flaw, though, we’re given one of the simplest strategies to beat the market: Invest in an equal-weighted index, not a market cap-weighted one.

The Power of Equality

Equal-weighting a portfolio means all positions are just that: equal.

When we look at the performance of an equal-weighted index versus the market, we see a stark difference in terms of performance.

Below is the 10-year chart of the Guggenheim S&P 500 Equal Weight ETF (NYSE: RSP) versus the SPDR S&P 500 ETF (NYSE: SPY)…

equal-weight-the-easiest-way-to-beat-the-market

These exchange-traded funds are made up of the same companies. They have the same components.

The only difference is how they’re weighted.

Over the last 10 years, the Guggenheim S&P 500 Equal Weight ETF returned 102.3% while the SPDR S&P 500 ETF gained 67.19%.

Over the last five years, the Guggenheim S&P 500 Equal Weight ETF gained 100.99% as the SPDR S&P 500 ETF gained 84.67%. And over the last two years, the Guggenheim S&P 500 Equal Weight ETF returned 40.18% with the SPDR S&P 500 ETF returning 36.24%.

So, we see in the near, medium and long term, the equal-weighted ETF outperforms the market cap-weighted ETF. And the longer the strategy is applied, the wider the gap becomes.

The results are clear. The simplest way to “beat the market” is to invest in an equal-weighted strategy. You’ll own the same stocks… but you’ll own different amounts of them.

Sometimes you don’t have to get fancy to outperform the broader markets. Sometimes the most effective approach is exploiting the market’s flaws at their most basic level.