Is the Invesco S&P 500 Equal Weight ETF a millionaire maker?

If you’re a fan of exchange-traded funds, then you’re probably also a fan of index investing. Most ETFs are built to reflect the performance of an index such as S&P 500after all. Indeed, the world’s most widely held exchange-traded fund is SPDR S&P 500 ETF Trust meant to mirror the world’s most well-known market barometer.

But what if you’re still indexing wrong?

The question seems crazy at first. Index investing is the only surefire way to ensure that you never underperform the broad market because you are simply buying and owning a balanced portion of the broad market. It’s hard to do wrong, right? That’s why so many millionaire investors choose it as their core portfolio holding.

In some circumstances, however, you may not get all you can from the simple indexing strategy. Here’s why and what you can do about it.

Not all indexes are built the same

Don’t panic if you already own a holding in the SPDR S&P 500 ETF Trust mentioned above. You will be fine. At an average annual return of around 10% per annum, regular investments in this fund will eventually take you into seven figures.

Either way, the next time you have some idle cash to put to work, consider entering in a similar but different way. Invesco S&P 500 Equal Weight ETF (RSP 0.62%) instead.

As the name suggests, this Invesco fund holds equal-sized positions in each of the components of the S&P 500. This is in contrast to the regular S&P 500, which is a cap-weighted index. That is, the larger the company, the greater its overall impact on the value of the index.

For example, enormously Apple it currently represents nearly 7% of the total value of the S&P 500, while much less Coca cola it represents only about 0.5% of the index. However, for the Invesco S&P 500 Equal Weight ETF, both companies reflect about 0.2% of the fund’s total assets. In equally weighted indexes, smaller companies have as much of an impact on index performance as larger companies, for better or for worse.

The structural difference between these two types of ETFs — and their underlying indices — raises a key question. Given that the performance of all stocks differs over time, how does the Invesco fund maintain a 0.2% weighting of each of its holdings?

It’s simple, really. The asset manager buys and sells shares as needed once a quarter to bring the ETF positions back to the target balance. And this continual rebalancing can make a world of difference to you.

The S&P 500 is not as well balanced as you might expect

You’ve probably felt it even if you don’t consciously know it. I mean, over the past few years, the biggest companies on the stock market have been making a lot of money, much bigger ones, while the smaller ones didn’t grow nearly as well. Invesco’s number crunching shows that in 2017, the market’s 10 biggest names together accounted for just over 21% of the total value of the S&P 500. Today, they account for nearly a third of the index’s value, and that proportion is still growing.

There is nothing inherently wrong with this switch to being very hard. After all, the reason you buy and own index funds in the first place is to participate in market growth led by the market’s top stocks at any given time — whichever stocks happen to be. Mission accomplished.

These past few years, however, have been an exception to the rule, posing a risk to investors who came along on the bullish course. This is because many of the factors that have enabled mega-cap stocks like Apple, Nvidiaand Microsoft to grow — higher interest rates, an economic slowdown, the rise of artificial intelligence) and more — no longer apply.

This presents an opportunity for smaller companies to catch up. And it’s not like we haven’t seen such leadership before, albeit on a less dramatic scale. Since its inception in April 2003, the Invesco S&P 500 Equal Weight ETF has effectively outperformed the SPDR S&P 500 ETF Trust, even with the large-cap-led S&P 500’s heroic performance since the start of last year.

RSP Total Return Level data by YCharts

Past performance is no guarantee of future results, of course. It’s certainly possible that the top S&P 500 could continue to outperform the Invesco fund and the S&P 500 Equal Weight Index it’s based on.

The cliché caveat, however, typically applies to more aggressive and active stock-picking strategies. The performance comparison made above is rooted in the well-proven investment premise that More balance is better than Less balance when the future is not predictable.

And the future is never really predictable.

Enough of an advantage to count

Again, don’t panic if you currently own a fund that mirrors the cap-weighted version of the S&P 500. It may not matter much after all, if it matters at all. There is no need to sell a position, especially if this could be a taxable event.

By the same token, you know that Invesco’s regular quarterly fund rebalancing creates recurring tax liabilities for positions held outside of tax-deferred retirement accounts. The ETF’s annual turnover is on the order of 20% (although the actual distributions of capital gains tend to be very, very small). While this may mean a lower tax liability if and when you sell the fund in the future, it can be a nagging nuisance in the meantime.

Still, if you think index investing is the highest-stakes, lowest-risk, and easiest way to become a millionaire, this slight twist on the idea of ​​this ETF at least reduces your overall risk. It can also deliver above-average returns, reaching the seven-figure mark a little faster than you would with a slightly different instrument.

Just something to think about in an environment that is still pretty choppy around simple index investing.