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ETF Specialist

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

A relatively high fee and structural impediments encumber SPDR S&P 500's performance.

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 SPDR S&P 500 (SPY) offers investors diversified exposure to U.S. large-cap stocks. The S&P 500 is the most oft-cited proxy for the U.S. equity market. SPY is the most heavily traded security in the world. This level of liquidity makes it very inexpensive to trade in large amounts, which is an attractive feature for traders and institutions with relatively short anticipated holding periods. While the fund's low expense ratio gives it a big leg up relative to peers in the large-blend Morningstar Category, structural issues hinder its tracking efficiency. So while a low-cost S&P 500 index fund or exchange-traded fund is generally a good bet for obtaining exposure to large-cap U.S. stocks, there are better S&P 500 funds available.

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.

Ben Johnson has a position in the following securities mentioned above: VOO. Find out about Morningstar’s editorial policies.