If you’re looking to invest in S&P 500 stocks, but don’t have the temperament to sift through and analyze the financial fundamentals of 500 individual companies, an S&P 500 Index fund or exchange-traded fund (ETF) can help you gain exposure to all those stocks—without the grueling analysis.
The S&P 500 Index tracks the largest and most dynamic companies in the United States. The index’s constituent stocks are curated by the S&P Index Committee, which selects companies based on a number of factors, including market cap, liquidity, and sector allocation.
In 1976, Vanguard introduced individual investors to the nation’s first mutual fund designed to mimic the S&P 500 Index. 17 years later, the first exchange-traded fund (ETF) was launched, which similarly tracked the S&P 500 Index. Today, nearly all major brokerages and fund companies offer some type of S&P 500 fund. Investors may access these funds through financial advisors, full-service brokers, or discount brokers.
Both index mutual funds and exchange-traded funds (ETFs) maintain a strategy of passive index replication, affording investors broad access to all of the securities within the given index.
The many funds that track the S&P 500 index generally have very low management fees.
What is the S&P 500 Index?
The S&P 500 Index was launched in 1957 as the first U.S. market capitalization-weighted equity index and is widely regarded as the best single gauge of large-cap U.S. equities. The S&P 500 is perhaps the most influential equity index in the world, with trillions of dollars indexed or benchmarked to it. The index consists of 500 leading U.S. companies, although the actual number of companies can vary slightly (there were 505 companies in the index as of December 17, 2021). The combined market value of all the companies included in the S&P 500 Index was $39.23 trillion (as of Dec. 17, 2021), representing 80% of available U.S. market capitalization.
Trillions of dollars indexed to S&P 500
As of December 31, 2020, an estimated USD 13.5 trillion was indexed or benchmarked to the S&P 500, with index funds and ETFs comprising about USD 5.4 trillion of this total.
The stocks in the S&P 500 reflect the growth drivers of the U.S. economy to a significant extent. For example, as of December 17, 2021, the Top 10 constituents of the S&P 500 by index weight were – Apple, Microsoft, Amazon.com, Tesla, Alphabet Inc A, Nvidia, Alphabet Inc C, Meta Platforms, Berkshire Hathaway, and JP Morgan Chase. Apple was the biggest constituent with a 6.7% weight, while the Top 10 stocks collectively made up 30.4% of the index. These mega-cap stocks, which dominate the U.S. and global markets, are concentrated in three sectors:
Information Technology, the biggest weight in the S&P 500 index, at 29.3%;
Consumer Discretionary, the second-largest weight, at 13.2%; and
Communication Services, the fifth-largest at 10.4%.
These three sectors combined account for over 50% of the S&P 500, reflecting the dominance of technology and related sectors in the U.S. economy. Other large sectors in the S&P 500 are Health Care (12.7%) and Financials (10.8%). These five sectors together constitute just over three-fourths of the S&P 500. The other six sectors – Industrials, Consumer Staples, Energy, Real Estate, Materials and Utilities – combined make up the balance 23.6% of the S&P 500 (as of Dec. 17, 2021).
ETF vs. Mutual Fund
An investor cannot invest directly in an index, since an index is simply a measure of the performance of its constituent securities. Index investing can be achieved very efficiently through ETFs and index funds that seek to replicate the performance of specific indexes.
ETFs primarily focus on passive index replication, essentially giving investors access to all securities within the specified index. Thus, an S&P 500 ETF gives an investor exposure to all the stocks in the index. These ETFs generally offer low-cost expense ratios due to minimized active management, and trade throughout the day, similar to stocks. Consequently, they are highly liquid, and subject to intra-day price fluctuations—just like stocks.
Currently, the largest S&P 500 ETF is State Street Global Advisors’ SPDR S&P 500 ETF (SPY), which had $436 billion in assets under management (as of Dec. 16, 2021). SPY was launched in January 1993, and was the very first ETF listed in the U.S.
S&P 500 index funds tend to have slightly higher fees than ETFs because of higher operating expenses. Furthermore, as a mutual fund has a structure that differs slightly from that of an ETF, investors can only buy it at the day’s closing price, which is based on the fund’s net asset value (NAV).
Index investing pioneer Vanguard’s S&P 500 Index Fund was the first index mutual fund for individual investors. The Vanguard 500 Index Fund Admiral Shares (VFIAX) is the largest index fund, with total assets of $827.2 billion (as of November 30, 2021).
Buying an S&P 500 Fund or ETF
Those looking to cheaply invest in S&P 500 ETFs may gain exposure through discount brokers, who offer commission-free trading on all passive ETF products. But keep in mind that some brokers may impose minimum investment requirements. S&P 500 index funds also trade through brokers and discount brokers and may also be accessed directly from the fund companies. Some investors may wish to manage their portfolio through an advisor or a broker, while others might prefer to manage a portfolio of funds that are all housed within a specific mutual fund provider. Investors may also access mutual funds and ETFs through employer 401k programs, individual retirement accounts, or robo-advisor platforms.
Why Invest in the S&P 500?
The S&P 500 has been a consistent performer over the long term. Since its inception in March 1957, and as of December 17, 2021, it had generated annual returns of 11.28% (based on FactSet data). In the 10-year period ended December 17, 2021, the S&P 500 had generated annual returns of 16.55%.
Investing in an S&P 500 ETF or fund is a single-ticket solution to get exposure to many of the world’s most dynamic companies in the largest economy. It does away with the need for an investor to spend countless hours in analyzing and picking stocks; after all that time and effort, the investment performance may be well below the results that could be obtained merely by investing in an S&P 500 index fund or ETF, since it is extremely difficult to beat the market.
Legendary investor Warren Buffett has some sage advice for wannabe stock pickers. Buffett has reiterated on multiple occasions that the average investor is best served by investing in an S&P 500 index fund, and not by trying to pick stocks. At the 2021 Berkshire Hathaway AGM, Buffett hammered home this point by noting that of the 20 largest companies in the world by market capitalization in 1989, not one remains among the top 20 today.
Pros and Cons
Some of the benefits of investing in the S&P 500 include –
Exposure to world’s most dynamic companies: Investing in the S&P 500 gives an investor exposure to some of the world’s most dynamic companies, such as Apple, Amazon, Google and Tesla.
Consistent long-term returns: Although returns in any single year can vary widely, over a long-term period of time, the S&P 500 has been a consistent performer.
Intricate analysis not required: Investing in the S&P 500 through an ETF or index fund means that you do not have to spend hours in analyzing and picking stocks in a futile attempt to beat the market.
Can be used as core holding: S&P 500 index funds and ETFs are very liquid and trade with tight bid-ask spreads. This makes S&P 500 funds and ETFs ideal as a core holding for most investment portfolios, and makes them suitable for advanced strategies like covered calls and hedging.
Drawbacks of investing in the S&P 500 include –
Index is dominated by large-cap companies: The S&P 500 is dominated by large-cap companies, with its ten biggest constituents accounting for almost one-third of the index. The median market cap of its constituent stocks was $32 billion as of December 17, 2021. This means that the S&P 500 index does not have any exposure to small-cap and mid-cap stocks that may have the ability to grow much faster than large-cap stocks.
Index has risks inherent in equity investing: The S&P 500 has risks inherent in equity investing, such as volatility and downside risk. For example, the index lost almost one-third of its value in the space of a few weeks in March 2020. Newer investors may find it difficult to tolerate such volatility.
Only includes U.S. companies: The S&P 500 only includes U.S. companies, and excludes companies in other parts of the world such as Asia and Europe.
Advancing Beyond the Passive S&P 500 Index Fund
Investors in search of a more advanced approach to S&P 500 fund investing may wish to consider smart beta indexes, which impose lower costs, and offer the advantage of fundamental or customized investing. Examples of such funds include the AAM Dividend Fund (SPDV) and the S&P 500 Equal Weight Index Fund (RSP). Investors may also target certain segments of the S&P 500 Index that offer capital appreciation potential, with funds like the SPDR sector series or dividend-focused funds.
Many fund managers also offer active S&P 500 funds, which focus primarily on S&P 500 names, but actively trade names beyond those strictly found in the index. There are also leveraged funds, which offer a simplified hedging approach. Bullish leveraged funds use leverage to multiply the return of the S&P 500 when it performs well. Bearish leveraged funds short the S&P 500, to pull in positive returns when the index falls.
Should I invest in the S&P 500 through an index fund or ETF?
Since there’s very little to choose between the two, it really depends on whether you want the intra-day liquidity of an ETF. For some investors, the ability to trade the S&P 500 intra-day, like stocks, is the main reason for choosing an ETF over an index fund. If intra-day liquidity is important to you, consider an S&P 500 ETF over an index fund.
Is there much difference in the fees charged by ETFs and index funds?
Not much; the difference in fees is marginal. For example, some of the biggest and most popular S&P 500 ETFs have an expense ratio of 0.03%. Vanguard’s S&P 500 ETF (VOO) has an expense ratio of 0.03%, while the Vanguard 500 Index Fund Admiral Shares (VFIAX) has an expense ratio of 0.04%.
Do S&P 500 ETFs and funds pay a dividend?
Yes they do, based on the dividends paid by the constituent companies of the S&P 500. The S&P 500 index has a dividend yield of about 1.3% (as of December 17, 2021).
Is an S&P 500 ETF or fund a suitable investment for a non-U.S. investor?
Depending on their risk tolerance, investors outside the U.S. should generally have some exposure to the U.S. equity market as part of a diversified portfolio. For such overseas investors, the obvious currency risk (which can be hedged) is more than offset by the stellar long-term performance record of the S&P 500.
What are the criteria for a company to be included in the S&P 500?
Some of the criteria for a company to be included in the S&P 500 are:
must be a U.S. company;
should have an unadjusted market cap of at least USD 13.1 billion, and a float-adjusted market cap of at least 50% of that minimum threshold;
must have positive as-reported earnings over the most recent quarter, as well as over the four most recent quarters summed together;
ratio of annual dollar value traded to float-adjusted market cap should be at least 1.00, and stock should trade a minimum of 250,000 shares in each of the six months leading up to the evaluation date.