S&P funds are not standardized


Published: Monday, January 19, 2004 at 6:01 a.m.
Last Modified: Monday, January 19, 2004 at 3:03 a.m.

Q:

I want to invest $10,000 in the Standard & Poor's 500 Index, which, as of this letter, is up almost 18 percent for the year. But my broker thinks I would be better off if I bought the Rydex S&P 500 (which owns the exact same stocks) because, so far this year, it's up 28 percent.
Can you please explain this to me? Why would Rydex S&P 500 do so much better than the S&P 500, which owns the same stocks? I think they are fixed-portfolio stocks. So why would the Rydex outperform the S&P? My broker says that he's "just unable to explain it." Can you tell me in simple English why one would do better than the other?

A:

First you need to know that both are exchange-traded funds. Exchange-traded funds are part mutual fund and part common stock and they've been putting profits and losses in investors' portfolios for years. That's the first thing this broker should have told you.
He also should have told you that like a mutual fund, an ETF is a portfolio of sector-specific stocks, such as just telecommunication issues or energy or biotech or broadband issues, etc. Like a mutual fund, an ETF can also be a portfolio of country-specific issues such as Mexican stocks or Japanese stocks or European issues. And, like a mutual fund, an ETF can be a broad market index, such as just the Russell 1000 or the S&P 500 or the NASDAQ 100.
An ETF is a passive investment and does not have a portfolio manager who actively buys and sells stocks. Unlike a mutual fund, an ETF can trade either above or below the net asset value of its portfolio. Unlike a mutual fund, an ETF can be shorted and can be bought or sold at any time during the day rather than noon or 4 p.m. Unlike a mutual fund, an ETF generally has a much lower expense ratio, and, unlike most mutual funds, it is tax-friendly and tax-efficient.
Now, quick as a blink, present your broker with an 18-karat gold star for his Rydex S&P recommendation and then, faster than a wink, take it back for his failure to explain why RFS has outperformed SPX since April. But you can send me the gold star because I can tell you why.
The SPX is a basket of 500 stocks that make up the S&P 500 Index, which is regularly quoted by newspapers, television and various financial publications. However, the SPX is divided into five categories of 100 stocks per category based on market capitalization. For instance, the first category of 100 stocks would contain issues with market capitalizations between $325 billion down to $10 billion. These are called large cap issues and these 100 stocks (General Electric, IBM, AT&T Corp., Microsoft, Exxon Mobil Corp., General Motors Corp., DaimlerChrysler, Merck & Co. Inc., Intel Corp., Citicorp, Philip Morris, Ford, Coca-Cola Co., J.P. Morgan Chase & Co., Johnson & Johnson and 83 more) represent 69 percent of the entire market value of the SPX.
Now, the next 100 largest stocks ($10 billion Cap to $3 billion Cap) comprise 15 percent of the entire average. The third-largest 100 issues with a market cap between $3 billion and $700 million represent 9 percent of the average. The fourth-largest 100 stocks with a market cap between $700 million and $150 million represent 5 percent of the S&P average.
On the far end of the spectrum are the micro cap issues that have a market capitalization below $100 million (like Lamson & Sessions, Nashua Corp., Green Mountain Power Corp., Green Mountain Coffee Roasters Inc., Cryolife Inc., Semco Inc., Extended Systems and 92 more) make up 2 percent of the market capitalization of the S&P 500. So, as you can see, the SPX is heavily weighted (69 percent) toward the big cap issues.
Now, the RPS owns the same stocks but has an equal dollar amount invested in each of the five categories. So 100 of the large cap issues (GE, IBM, AT&T, Microsoft, etc.) represent only 20 percent of the RPS portfolio rather than the 69 percent that comprises the SPX portfolio. The next 100 largest stocks, with market caps between $10 billion and $3 billion, also represent 20 percent of the RPS portfolio rather than the 15 percent of the SPX portfolio. Finally, 100 of the micro-cap issues with market caps below $100 million also represent 20 percent of the RPS portfolio rather than the 2 percent of the SPX portfolio.
Since April, it seems that the smaller cap issues have performed between 40 percent and 50 percent better than the large cap issues, which is why the RPS has gained 28 percent vs. the SPX gain of 18 percent.
Now, this doesn't mean that RPS will always outperform the SPX. But if you're considering this as a long-term investment, I'd consider buying a round lot of both the SPX and the RPS and cover all bases plus the foul lines and fences.
n n n

Q:

I manage my own account and need your advice. I think I should buy 300 shares of Flextronics International. I owned 300 shares in 1994 at $21 and regretfully sold them in late 1997 at $36, making a $4,500 profit. The company has changed a lot in the past six years.
What do you think about my purchasing 300 shares again? How high do you think the shares can go in the next three to four years? I can afford some risk. But before I go out on a limb I would feel more comfortable with an opinion from you.

A:

You can put Flextronics Corp. (FLEX) in your portfolio and I think 300 shares sounds about just right.
FLEX makes and designs advanced electronics for original equipment manufacturers, for hand-held devices, computers, wireless and information technology infrastructure, consumer electronics and the industrial, automotive and medical industries.
This sector seems to have emerged from the bottom of a very bloody cycle both at home and abroad. The slump of the past three years saw demand collapse, painting this sector with red ink while many issues imploded to between 70 percent and 95 percent of their high market values.
However, month-to-month revenue comparisons have been trending higher and December was the ninth month of consecutive revenue growth. So it appears that this sector has turned the corner and FLEX looks like one of its promising companies.
Personal computer growth held up well with good growth in microprocessors and dynamic random access memory, which reflects the early stages of a business upturn as well as seasonal "back-to-school" demand. But the consumer sector, which held up well during the downturn, thanks to DVD players, hand-held devices, digital cameras and the growing popularity of electronic games. In fact the suits on Wall Street are anticipating an extremely strong rebound through 2006-07.
This rebound is not consumer-specific, but it seems that corporate America has a massive bottled-up "wish-list" that may generate significant new commercial and industrial demand. The potential over the coming two to four years could be enormous.
FLEX's revenues have grown nicely every year since 1993 and revenues continued to grow during the bloodbath after the bubble burst. Unlike most of its competitors, according to the estimable Value Line, Flex continued to make money in 2000, 2001, 2002 and 2003, when most of the competition was sliding down a hill of horrors.
Revenues in 1993 were $123 million, reached $4 billion in 1999, jumped to $13 billion in 2000 and are expected to exceed $14.5 billion this year. Some Wall Street analysts believe that FLEX's revenues could grow to $22 billion in three to four years with earnings that could approximate $2 a share.
So with blue chip customers like Casio, Dell, Alcatel, Hewlett-Packard, Microsoft, Motorola, Siemans, Sony Ericcson and Xerox contributing 65 percent of sales, FLEX should have the potential revenue and earnings power to move its share price to the low $40s in the coming four years.
If management can improve its net profit margins to 5 percent, as they believe they can, then FLEX may certainly be a good long-term growth stock. Common stock represents 76 percent of capital and the board split the stock 2-for-1 three times between 1998 and 2000, when it reached a post-split high of $44 a share.
During the "bubble years," FLEX traded at an average price-earnings ratio of 38, which, in my opinion, was egregiously high. I feel an average P/E of 22 is certainly more acceptable. While I consider the shares a bit on the risky side, I'm very comfortable confirming your decision to purchase 300 shares.
If FLEX can earn an expected $2 a share, a P/E of 22 could put the share price at $44. That's a nice gain if you can get it. And I must disclose some of our clients own FLEX.
Please address your financial questions to Malcolm Berko, P.O. Box 1416, Boca Raton, FL 33429 or e-mail him at malber@adelphia.net.

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