Not All S&P 500 Index Funds Are Created Equal

Superlatives surround the SPDR S&P 500 Trust (SPY ). It is the oldest exchange-traded fund, launched in 1993. It is the largest, at $148 billion. And it is the most-traded ETF, with average volume of 100 million shares, or 20 times that of Wal-Mart Stores Inc. (WMT ).

What SPY is not: the best-performing ETF tracking the S&P 500. In fact, it's the worst-performing of the three ETFs that track all 500 stocks and have 10-year records.

SPY's main rival, the $46 billion iShares Core S&P 500 ETF (IVV ), is beating it by 0.48 percent over 10 years, or $48 for every $10,000 invested. That's why IVV has a higher percentage of buy-and-hold investors than SPY, which is 83 percent owned by institutional owners that value its ocean-deep liquidity. (Institutions own 51 percent of IVV, data compiled by Bloomberg shows.) IVV is also a hair cheaper, with an expense ratio of .07 percent to SPY's .095 percent.

The big reason SPY trails the iShares fund is that it's structured differently. IVV is an open-end fund, like many ETFs and mutual funds; SPY is a unit investment trust (UIT). An ETF's structure is an oft-ignored data point that can affect performance.

Cash Drag

Of the 1,497 ETFs, more than 300 aren't open-end funds but have structures including grantor trusts, statutory trusts, UITs and partnerships. SPY, like some other of the oldest and largest ETFs, falls in this category because when it was created UITs were the only structure acceptable to the Securities and Exchange Commission.

Being first to market has proved a powerful brand advantage for SPY. Being a UIT makes life a little more restrictive, however. The most notable difference is that dividends can only be reinvested quarterly, whereas open-end funds can reinvest dividends daily. This creates a slight cash drag for SPY and accounts for the bulk of the 0.48 percent difference compared to IVV over the past decade. Also, unlike UITs, open-end funds can lend out their securities and collect fees that can enhance total return.

The $5 billion Guggenheim S&P 500 Equal Weight ETF (RSP ) also tracks S&P 500 stocks, and is a big favorite of retail investors -- institutions own 36 percent of RSP. It has handily outperformed both SPY and IVV over the last 10 years with a total return of 143 percent, or 44 percent more than SPY. That's $4,400 for every $10,000 invested.

More Voice

Rather than weight its holdings by their market capitalization, RSP equally weights every stock in the S&P 500; each S&P 500 member gets a 0.20 percent weight. That gives more voice to the smaller of the large-cap stocks in the index, which typically get drowned out in market-cap-weighted funds like SPY and IVV. In this way, RSP is a lot like the U.S. Senate, where each state gets an equal vote, while market-cap-weighted SPY is more like the House of Representatives, where representation is based on population.

If smaller large-caps do well, they can boost the overall return of RSP over rivals. Take Constellation Brands Inc. (STZ ), the maker of Corona beer. The $11 billion large-cap stock is up 215 percent over the past two years. It has the standard 0.20 percent weighting in RSP; it's 0.04 percent in SPY. Its higher weighting in RSP translated into a 0.28 percent greater contribution to the two-year return of RSP than to SPY. When you have dozens of examples like that, they start to add up.

RSP's equal-weighting mandate also means that when the fund rebalances its portfolio each quarter, it has to sell stocks that have been on a run and reallocate the money to stocks that haven't been doing well. That effectively means the ETF is selling winners, taking profits and buying losers, a method used by many professional investors.

It's easy to dismiss RSP as not being a legitimate S&P 500 ETF because it isn't market-cap-weighted. But there's no law saying that market-cap weighting has to be the standard way indexes are created. Critical articles have also warned of RSP's "small-cap tilt." But RSP doesn't invest in small-caps. It owns the same 500 stocks as SPY. What RSP has is a tilt toward smaller large-caps, which is very different from having actual small-cap exposure, which would mean owning companies 10 to 20 times smaller than those in the S&P 500.

One concern with RSP is how it performs during selloffs and bear markets. During the bear market of 2008, it trailed SPY by 3.4 percent, in part because investors fled to the perceived safety of the largest large-caps. In a panic, it seems, equality has its downside.

Eric Balchunas is an exchange-traded-fund analyst at Bloomberg. More ETF data is available here , and weekly ETF podcasts can be found here .

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