This ETF Might Be the Biggest S&P 500 Tracker, but It Isn't the Best

SPY is set up as a unit investment trust. This structure leads to several disadvantages relative to other S&P 500 funds. SPY's managers cannot use index futures to manage cash, are restricted from reinvesting dividends, and are unable to engage in securities lending. These features, along with a modestly higher fee, have resulted in inferior long-term tracking performance relative to other ETFs and index mutual funds offering exposure to the S&P 500. However, SPY does have a more-liquid options market and is often used by institutional traders as a substitute for S&P 500 futures contracts. Though these advantages really only appeal to institutions that place a premium on short-term liquidity, firms looking to arbitrage price differentials between various instruments tied to the index, or high-frequency traders.

A low fee and a soundly constructed and reasonably representative benchmark leave SPY well-positioned to continue its long streak of producing superior risk-adjusted returns relative to its category peers over the long haul. That said, there are better options available for long-term investors looking for exposure to the index. Many would be marginally better off with S&P 500 ETFs from Vanguard and iShares or mutual funds from Vanguard or Fidelity, all of which levy lower fees relative to SPY and aren't encumbered by the same structural disadvantages.

Fundamental View The S&P 500 was first created in 1957. It was the very first market-capitalization-weighted index of U.S. stocks. Its well-known predecessor, the Dow Jones Industrial Average (which was first calculated in 1896), is a price-weighted index. In 1896, weighting stocks on the basis of their share price made sense in that it wasn't very computationally intensive (electricity was still a fairly recent invention back then). Sixty years later, computing power had advanced significantly, making it easier to build and calculate an index that better reflects the overall performance of U.S. large-cap stocks, one that selects and weights its constituents chiefly on the basis of their market capitalization.

Over its history, the S&P 500 has proved a difficult hurdle for many U.S. large-cap managers to clear. The first S&P 500 fund,

Many attribute active managers' collective struggles to best index funds to the overall level of efficiency of the market for U.S. large-cap stocks. Efficiency in this case is meant to indicate the speed and precision with which market participants incorporate new information (economic news, earnings data, and so on) into stock prices (by selling on bad news, buying on good news). Furthermore, given advances in information technology and the growth in the portion of investable assets that is managed by an increasingly skilled set of professional investment managers, it can be argued that the market has become ever-more efficient over time. But market efficiency alone does not explain the long-term success of broadly diversified market-capitalization-weighted index funds.

The second leg of the investment thesis for index funds is their cost advantage. Index funds are inherently less expensive to manage than actively managed alternatives. Their sponsors don't have to pay teams of well-educated and highly credentialed portfolio managers and investment analysts to identify under- or overvalued stocks to be added to or sold from their portfolios. Also, market-cap-weighted index funds have lower turnover relative to actively managed funds. Turnover has a price. Commissions, bid-ask spreads, and market impact costs all add to the headwinds facing active strategies. Also, turnover has tax implications. Higher-turnover actively managed funds will regularly distribute taxable capital gains to their shareholders. This creates an additional drag on the performance of actively managed funds in the case where they are held in investors' taxable accounts. Taken together, these costs are the largest and most persistent drag on the performance of actively managed strategies.

Market-capitalization-weighted indexes like the S&P 500 have some noteworthy drawbacks. By owning "the market," investors are relying on other market participants to price stocks on their behalf. While over long stretches of time market participants have done a good job of valuing stocks, these long horizons have been marked by episodes of mania and panic. The mania most often cited as an example of the drawbacks of owning the S&P 500 outright was the technology bubble, when technology stocks accounted for nearly one third of the index's market cap. Episodes like this are unavoidable for index investors and create opportunities that have historically been exploited by (some) active managers.

Portfolio Construction This fund tracks the S&P 500, a market-cap-weighted benchmark composed of mega-, large-, and some mid-cap U.S. stocks. This index has a slight quality tilt because of its conservative eligibility requirements pertaining to unprofitable companies and recent IPOs. However, that does not mean that the index will have superior performance or that unprofitable companies will be removed from the index on a timely basis. Constituents are determined by a set of criteria and an index committee. The presence of the index committee gives the S&P 500 a greater degree of flexibility relative to most other indexes that follow more mechanical rules. Per S&P Dow Jones Indices, the smallest constituent of the index as measured by market capitalization was $2.5 billion as of the end of August, 2016. The average market capitalization of the stocks included in the index was $39 billion. The constituents of this index account for approximately 80% of the total market cap of the U.S. stock market. As this fund holds large stakes in multinational firms, it also has substantial indirect international exposure. About half of the index's constituents' revenue is generated outside of the U.S. Unlike most modern ETFs, SPY is organized as a unit investment trust, which prevents it from reinvesting dividends, holding securities that are not in the index, such as futures, or lending securities. This leads to slightly higher holding costs. It also has a one-month lag between the ex-dividend date and the payment of dividends. The fund follows a full replication strategy, holding every stock in the index.

Fees This ETF's 0.0945% expense ratio, while low in absolute terms relative to peers in the large-blend category, is not the lowest among ETFs and index funds tracking the S&P 500. During the five-year period ended Aug. 31, 2016, the fund lagged the S&P 500 by about 17 basis points annualized. The approximately 8 basis points of annualized tracking difference that cannot be attributed to SPY's fee reflect, in part, the fact that it has been unable to reinvest dividends or use futures to equitize cash during a bull market for the S&P 500.

Alternatives SPY has greater trading volume and assets under management than any other ETF. But its liquidity advantage is somewhat overshadowed by its relatively higher fee and structural deficiencies. Given its abundant liquidity, frequent traders and investors moving tens of millions of dollars over very brief periods of time will likely prefer to use SPY over its closest peers.

While SPY is structured as a unit investment trust,

A total stock market ETF may be more appropriate for investors looking for exposure to the broad U.S. market in one fund.

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