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Taking Stock of the S&P 500 Index

We review the S&P 500 Index fund options and discuss why the market may not be as overvalued as the CAPE suggests.

Michael Rawson, CFA, 01/10/2014

Since 2005, equity investors have put nearly $1 trillion into passive mutual funds and exchange-traded funds while pulling $300 billion out of active funds. Although the Dow Jones Industrial Average may be older and more widely cited, the S&P 500 Index's market-cap weighting makes it closer to the ideal "market portfolio" envisioned in the efficient-market hypothesis. The S&P 500 has become the most popular index that mutual funds and ETFs track. There are 54 distinct mutual funds indexed to the S&P 500 and three ETFs. Of these, only a handful can justify their existence.

An S&P 500 Index fund can serve as an effective building block for exposure to United States equities. The index contains with 500 of the largest publicly listed U.S. companies. And for the most part, it has lived up to the expectations of the efficient-market hypothesis, proving to be extremely difficult for active managers to beat consistently after fees. 

However, the S&P 500 lacks exposure to many mid-cap and all small- and micro-cap stocks. Although small in size, smaller-cap stocks historically have helped boost the performance of total-market indexes relative to the S&P 500 Index, with only a slight increase in risk. In addition, the S&P 500 is not as mechanically constructed as some other indexes because the committee that oversees it has some flexibility over index changes. For investors looking for diversified exposure to U.S. stocks, a low-cost S&P 500 Index fund is a worthy candidate.

Investment Options
While there are a lot of great options for exposure to the S&P 500 Index, there are also a lot of bad ones. There are 57 unique funds tracking the S&P 500 Index, and a total of 149 share classes with $737 billion in assets. But 90% of those assets are in just 15 share classes. In 2013, those 15 share classes had an average return of 32.28%, just 0.11% shy of the index. But there are also 54 share classes with less than $100 million and an average return of only 31.15%. 

While a lot of these smaller index funds carry higher expense ratios, they still might be appropriate for investors with a limited set of options. For example, employees limited to choices within a 401(K) plan that is littered with high-priced funds may still prefer a moderately priced index fund. The lowest-cost S&P 500 Index funds tend to be institutional share classes, which require large investment minimums. But in between the low-cost and midpriced institutional share classes, there are a lot of good choices.

Two funds with Morningstar Analyst Ratings of Gold, Fidelity Spartan 500 IndexFUSVX and Vanguard 500 Index VFIAX, charge 0.05% for investors who meet the $10,000 investment minimum. Silver-rated Schwab S&P 500 Index SWPPXcharges 0.09% with only a $100 investment minimum. Silver-rated DFA US Large Company DFUSX charges 0.08% but must be purchased through an approved financial advisor. ETFs require no investment minimum beyond the price of one share. iShares Core S&P 500 IVV charges 0.07%, while the largest S&P 500 Index fund, SPDR S&P 500 SPY, charges 0.09%. Vanguard S&P 500 ETF VOO charges 0.05% and is technically a separate share class of the Vanguard 500 Index mutual fund.

Each of these closely mirrored the performance of the index and each other. However, two funds deserve further mention. Among the ETFs, SPDR S&P 500 uses the older unit-investment-trust legal structure, which prevents it from reinvesting dividends, holding securities that are not in the index (such as futures), or lending securities. DFA allows itself slightly more flexibility when replicating the index. Instead of ramming through trades for index changes on the exact date that they occur, which may create higher than necessary transaction cost, DFA trades more patiently. While this does result in slightly higher tracking error, it also has allowed the fund to earn back its fee.

Michael Rawson, CFA is an ETF Analyst with Morningstar.
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