The Best Performing Factors That Consistently Beat the S&P 500
The S&P 500 index is constructed according to a set of rules. In essence, it selects and allocates greater weight to the largest U.S.-based stocks. It's remarkable that a straightforward market capitalization criterion can perform so effectively. However, one must exercise caution when applying this principle to markets outside the U.S., as many market capitalization indices do not perform as well. This topic merits further discussion another day.
Numerous attempts have been made to uncover the "secret sauce" for outperforming a market-weighted index. Academia introduced the concept of factors, which the financial industry has rebranded as smart beta. Both terms refer to the same concept: certain characteristics within stocks may increase their likelihood of outperforming the market index.
Regrettably, many factors do not perform in practice as well as they do on paper. To be fair, funds often do not implement the methods exactly as conducted in studies, opting instead for their own interpretations and renditions of the factors. This discrepancy could be attributed to execution challenges, as some factors may be difficult to implement, not to mention the impact of transaction fees and spread costs.
Despite these challenges, some factors have indeed outperformed, and Invesco offers a suite of smart beta ETFs applied to the S&P 500 Index for comparison against the traditional S&P 500 ETF.
Size Factor: Invesco S&P 500 Equal Weighted ETF (RSP)
The size factor suggests that small-cap stocks tend to deliver higher long-term returns compared to large-cap stocks. The S&P 500 is weighted towards larger caps, but the Invesco S&P 500 Equal Weight ETF (RSP) introduces a variation by normalizing the weighting and distributing it evenly across all 500 stocks. I have previously discussed this in a post, highlighting that RSP has historically outperformed the SPY in most periods: A Better S&P 500 ETF.
However, RSP has recently underperformed compared to SPY, a trend largely attributed to the significant outperformance of the "Magnificent 7." This does not imply that the size factor is diminishing in effectiveness. There have been periods of underperformance followed by outperformance, underscoring the principle that factors operate over the long term and do not guarantee annual returns.
