Article: Not Just Another Large Cap Fund

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Bill owns Capital Management Group, LLC. He has more than thirty years experience as an advisor on personal finances, taxes and investments. Bill has been recognized by Washingtonian magazine and other publications as one of the top financial advisors in Washington, D.C. Michael handles business development for Capital Management Group, and is currently pursuing his CFP designation.

The construction of our client’s portfolios can be boiled down to a three-step process.  First, we assess the client’s risk/return profile and projected cash flow needs.  Second, we develop an appropriate investment mix for that client, allocating their portfolio among various investment classes (e.g., large, mid, small cap and international equities).  Third, we select from a number of specific securities within each investment class.  We sometimes choose more than one fund tracking the exact same group of stocks.  Why would we do that?  A comparison of two funds we use – iShares S&P 500 Index (IVV) and Rydex S&P Equal Weight (RSP) – offers a good illustration.

Both funds track the performance of all the stocks in the S&P 500, but use different methods to determine the relative weight of each stock held by the fund.  Just like the S&P 500 index itself, IVV is weighted by market capitalization:  the largest companies take up the largest share of the portfolio, and when one company’s market cap grows relative to the others, its weight in the portfolio likewise grows.  On the other hand, in RSP, each stock in the S&P 500 makes up about 1/500^th of the fund:  tiny Gateway has as much weight as giant Exxon.  The managers rebalance quarterly to maintain that balance.

This one difference in weighting has some truly tangible implications, and gives each fund a specific role in the client’s portfolio.  IVV represents the large-cap market benchmark – it exactly mirrors the results of the S&P 500.  With an average market capitalization of $48 billion, it might be more accurately described as a mega-cap growth fund.  RSP’s equal weighting produces an average market cap of about $13 billion – barely enough to qualify as a large cap fund.  Plus, through regular rebalancing, money is periodically shifted from recent high-performing stocks to recent low-performing ones, giving RSP more of a value style.

Combining these two funds neatly captures two ends of the large-cap spectrum.  Using exchange-traded index funds (ETFs) to achieve diversification within the large-cap class is particularly effective for several reasons.  First, index funds must strictly adhere to their respective indices, avoiding style drift and thus maintaining their assigned role in the portfolio.  Second, with annual expenses of just 0.09% for IVV and 0.4% for RSP, we keep costs down.  Third, ETFs are famously tax-efficient, minimizing annual taxable distributions to shareholders.

A comparison of recent performance shows the bottom line difference that the two ETFs can produce:

                                                Market Returns through April 2006

By combining funds in this manner across all investment classes, investors can reduce risk AND capture potentially higher returns.

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