Reality Check

November 01, 2006

Morningstar recently bestowed its highest possible mutual fund honor on the Rydex S&P Equal Weight ETF (Amex: RSP), awarding it five stars for the three years ending June 30, 2006. The Morningstar rankings are based on risk-adjusted performance, with funds measured against other funds in the same category, i.e., large-cap growth funds against large-cap growth funds, small-cap value against small-cap value, etc. RSP was evaluated in the "large blend" category, and apparently, it compared well.

RSP is the idiot savant of strong performance. If I were an active fund manager, it'd drive me crazy.

Before we celebrate (and evaluate) RSP's performance, however, let's take a moment to pity the poor active fund managers in RSP's category. Imagine their fate: They've been staying up late, pouring over company filings; they've logged 100,000 air miles shuttling to and from conferences and corporate headquarters; their hair is turning gray; there are bags under their eyes; they haven't seen the sun in weeks. Maybe, if they are lucky, they are doing well

... maybe their performance is up, and they're looking at three or even four stars. Now, along comes RSP, flouncing by with its simple equal-weighting methodology, and it earns five stars without breaking a sweat. It is the idiot savant of strong performance. If I were an active fund manager, it'd drive me crazy.

I mean, let's be serious: The strategy winning these accolades could not be simpler: you hold all the stocks in the S&P 500 at equal (0.20 percent) weightings, and rebalance quarterly. That's it. No comparative analyses or complicated quant-driven programming. Instead, it's like a kid in a candy store: I'll take one of those, and one of those, and one of those…

I don't mean to criticize the fund. RSP has delivered 16.27 percent annualized returns to shareholders over the past three years, compared to just 11.22 percent for the traditional S&P 500. And there's a good body of evidence that suggests that two features of the fund - a pronounced mid/small tilt and regular rebalancing - are associated with improved performance. RSP manages to incorporate these features, and avoid emotion-driven performance chasing, all in one fairly inexpensive packet.

But the utility of the rating, like the utility of all Morningstar ETF ratings, is suspect. We know that RSP's portfolio sits on the very edge between mid- and large-cap exposure (57 percent large-cap and 43 percent mid-cap, according to Morningstar). With that in mind, the rating tells us … what, exactly? That small/mid-caps have outperformed large-caps over the past few years? Well, yeah …

And if small/mid-caps fall out of favor for a while???

I do think there is some utility in the Morningstar ratings for ETFs when applied to the fancy, quantitative strategies employed by the likes of Po w e r S h a res and its various hangers-on. After all, those funds are trying specifically to "beat the market," not to simply provide exposure to a given slice of the market. So it's a real endorsement that the PowerShares Dynamic Portfolio (Amex: PWC) - one of PowerShares' flagship "enhanced index ETFs"-also received a five star rating from Morningstar. (For what it's worth, PWC has outperformed RSP over the past three years.)

But for most ETFs, I'm not convinced. An index fund is an index fund, and it should be measured as such. How? One thing's for sure: A good place to start is with tracking error and fees.

So, congrats to RSP-they have an interesting fund that incorporates some basic good ideas for shareholders, such as rebalancing on a regular basis, and they've delivered strong returns. But my advice? Don't let it go to your head.

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