How to Beat the Traditional S&P 500 Index

John Bogle has been a thorn in the side of active stock pickers ever since the 1970s.

As an evangelist of index fund investing, Bogle has been preaching for decades that on average, stock pickers can’t outperform the market over the long term.

What’s most annoying is that — unlike most investment gurus — he’s been consistently right.

Over the past 25 years, only 38.6% of active funds have outperformed the broader S&P 500 on an annual basis.

And good luck with finding the fund that outperforms the S&P 500, year after year, over that time period, and in advance.

Active stock pickers’ consistent underperformance is due to a combination of bad judgment, higher trading and management costs and just plain human hope and hubris — believing that their subjective insight works better than just, well, buying the market and calling it a day.

Bogle’s own confidence in indexing must be reaching an all-time high in 2014.

While on average close to four out of 10 managers outperform the S&P 500 every year, this year that number has fallen to less than one out of 10.

If that holds, it just might be the lowest percentage ever.

Another couple of more years like this, and even the most ardent stock pickers will have a tough time believing they add value.

Truth be told, active stock pickers have had the deck stacked against them in 2014.

First, any stock picker invested in foreign stocks has had a millstone around her neck. The relentless “doom-and-gloomers” notwithstanding, the U.S. market has been one of the top-performing markets in the world in three out of the last four years.

Second, with small-cap stocks trailing U.S. large caps by over 10% this year, any active managers who invested in anything but the biggest stocks in search of value or better growth have had their heads handed to them.

Finally, sectors and investment themes have been going in and out of favor with unprecedented speed.

Last year, it was energy stocks that were hot. This year, these same stocks have collapsed while both high-risk biotech and low-risk utilities stocks have soared. There is little method to the madness of such rapid sector rotation.

Smart Beta Funds: A Better Mousetrap?

Being “dumb and long” in the U.S. index has trounced just about every active strategy out there.

But I’m here to tell you that there is even a better investment mousetrap.

As well as S&P 500 index funds have done in in the past 40 years, one group of funds has done even better.

In fact, as much as Bogle gets underneath the skin of active managers, it is “smart beta” or “alternative index” funds that give Bogle himself the woolies.

And for good reason.

“Smart beta” funds are like index funds in that they are passive.

The difference is that they are based on “alternative” indexes.

As it turns out, the index upon which a passive strategy is based makes all the difference.

And once you are willing to tweak the indexes, that is, how you define “the market,” there are all sorts of different ways you can skin this investment cat.

A traditional S&P 500 Index weighs stocks by market capitalization. The bigger the company, the bigger the weight in the index.

That’s why the top 10 stocks account for 17.87% of the S&P 500.

But it turns out you can construct an index using all sorts of other criteria: fundamentals, momentum or even by tracking companies buying back their own stock.

Let’s look at the simplest “alternative” index strategy.

Instead of weighting the S&P 500 stocks by market capitalization, take the same 500 stocks and weight them equally — and rebalance them at the end of every quarter to keep them from getting too far out of whack.

With this approach, the top 10 stocks will account for a mere 2% of the index.

This simple strategy has outperformed the traditional market-cap-weighted indexes by over 2% a year since 1967. So far this year, it has outperformed the indexes by a more modest 0.45%.

That is a massive difference, especially as you compound it over time.

Just take a look at the performance of the Guggenheim S&P 500 Equal Weight ETF (RSP) since it was launched in 2003.

So here’s my heartfelt recommendation:

Dump your traditional S&P 500 Index Fund, and buy the Guggenheim S&P 500 Equal Weight ETF (RSP).

And call me in 10 years to thank me.

In case you missed it, I encourage you to read my e-letter column from last week about how my favorite contrarian indicator shows Russia is ripe for a rebound. I also invite you to comment in the space provided below.