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A valid complaint regarding the S&P 500 index is that it is dominated by a relatively small number of large companies. (I like that small of large<grin>)

Rydex has developed an ETF that gives equal weighting to all 500 companies. The theory is that this would be more representative of "the market" since it holds all companies in equal amounts.

My humble opinion is that it would allow more true diversification. Plus by giving weight to smaller companies, you perhaps could have more a value play, think fallen angels.

For an ETF, its .4 annual expense ratio is a little high and there may be some tax inefficiencies due to the quarterly rebalancing.

Rydex S&P equal weight ETF trades under RSP.

www.rydexfunds.com/etf

www.indexuniverse.com

buzman


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and there may be some tax inefficiencies due to the quarterly rebalancing

Buzman,

Can you be more specific? ETFs have extremely low taxable distributions because they exploit a tax loophole for "in kind" trades. Rebalancing within an ETF is almost always not a taxable event. Is there some reason why this ETF does not or can not do this?

thanks,
Joe
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Greetings Joe,

ETFs have extremely low taxable distributions because they exploit a tax loophole for "in kind" trades.

This assumes a certain amount to volume to account for shifts in the portfolio as for the ETF to shift holdings without triggering taxes you have to have a certain amount of creation/redemption events which in some cases hasn't been there.

For a very specific example, let me quote from http://news.morningstar.com/doc/news/0,2,8745,00.html :
<snip>Because the iShares S&P 500 Index was just launched in May 2000, its portfolio of stocks is still small compared with its older rival, the SPDR. Indeed, when new "in-kind contributions" of stocks representing all the stocks in the S&P 500 were made to the fund in October, it nearly doubled in size. That fact put the iShares' managers in a bind. Although the fund had recently sold off stocks for tax-loss purposes, it couldn't use the losses because of the wash sale rule. That rule states you can't realize a tax loss from the sale of a stock if you repurchase that same stock within 30 days, and in the eyes of the IRS, the fund had essentially repurchased all its shares when it received the large in-kind contributions. Making matters worse is that fact that the reporting period for fund capital gains ends each year on October 31.

Not only could the fund not use tax-loss sales, but because the iShares 500 Index hadn't received many "in-kind redemptions," the managers hadn't been able to offload any gains onto institutional investors. As Jim Ross, who helps manage the SPDR, points out, ETF managers actually look forward to receiving "in-kind redemptions" since they allow an ETF to be more tax-efficient.
</snip>

Is there some reason why this ETF does not or can not do this?

The equal weight S & P ETF is supposed to be .2% in each of the 500 companies and each quarter has to get back to this from whatever happens to those stocks which would be ALOT more turnover than a market-cap weighted 500 which is somewhat naturally rebalanced except for the share counts that change each quarter. Whether the ETF will have sufficient volume to clear this hurdle is the question that time will tell.

I'd also note that the Mid-cap SPDR had capital gains distributions for its first few years that somehow seems to be ignored by some folks.

Regards,
JB
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The column that I read from CBS marketwatch confused me. I read it more carefully and I believe that I misinterpreted it.

I will contact the manager tomorrow to clarify.



Thanks for the headsup.

buzman
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Rydex has developed an ETF that gives equal weighting to all 500 companies. The theory is that this would be more representative of "the market" since it holds all companies in equal amounts.

Interesting, though personally I prefer cap weighted products. The magic of cap weighted investments is you can be certain 99% of the individual shares making up the fund are going to be the same this year as last. So transaction costs (commission, bid/ask, market impact) and cap gains pass-through will be low.

Also, how easy will it be to spot tracking error with this ETF? With the cap weighted products I can just compare to the S&P.

And I'm not sure such a product is more representative of the market than a cap weighted index. Take GE. It's really dozens of separate "businesses" conglomerated under one name. You'd get better economic exposure with more of this than say, Eastman Chemical. It's kind of like if you diversified your portfolio among countries. Would you want the same proportion of US stocks as those of say, Botswana?

I'm going to hazard a guess that this ETF will under perform the cap weighted ones long term.

Nick
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http://www.rydexfunds.com/website/pdf/factsheet_etf.pdf

Five years is not long term, but long term we will all be dead.
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Per my conversation with the fund manager, yes, RSP does have some capital gains.

They will try to manage them either thru "in kind" distributions or perhaps offseting them with cap losses.

I would note that RSP is far more tax-efficeint than most mutual funds just less as efficient a more conventional ETF.

ONe reason this fund as outperformed the S&P recently is the fact that it behaves more like a Mid-cap.

Perhaps this is more suited for qualified accounts, nonetheless it is a product which interests me.

buzman
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Perhaps this is more suited for qualified accounts, nonetheless it is a product which interests me.
buzman


Please forgive the ignorance, but could you define, "qualified"? I have seen this term before but never in context so I havent been able to figure out what it means, thanks in advance.

bundori
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I thought the explanation was much simpler. Most ETFs are cap weighted which means that as prices of the component stocks change, the weighting in the ETF shifts proportionally. Rebalancing due to price changes is not needed.

However, for an equal weighted index like this Rydex, any price change of a component stock will cause a shift in the balance. For example, when a single stock increases by 20%, this would cause the stock to be overweighted by 20%. Thus there will be a need for constant rebalancing. I think the fund only rebalances once per quarter, but this results in transaction costs and tax gains which would be passed along to the investor.
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ETFs have extremely low taxable distributions because they exploit a tax loophole for "in kind" trades. Rebalancing within an ETF is almost always not a taxable event. Is there some reason why this ETF does not or can not do this?

I don't know whether rebalancing within an ETF causes a taxable event to the shareholder or not, but, since this is not a cap weighted index, rebalancing will have to take place continually (quarterly), while in a cap weighted index, it stays nearly balanced automatically, and the only significant rebalancing required is when companies leave or are added to the index. The continual rebalancing need for this new ETF is probably what has caused it's high expense ratio of 0.4%.

Russ
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The continual rebalancing need for this new ETF is probably what has caused it's high expense ratio of 0.4%.

The scary thing is the real cost of all this rebalancing -the transaction costs- don't even show up in the ER.

The only way to back them out is to track the fund against a frictionless index. But does an index exist for equal weighted S&P 500 stocks? I guess you could roll your own pretty easily.

Nick
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