by Will Ashworth | January 30, 2012 8:30 am
Let’s assume for a moment that you’re interested in investing in Exxon Mobil (NYSE:XOM) because you believe multinational oil companies will continue to reap the benefits of a world thirsty for oil. However, you don’t have the funds necessary to own a diversified portfolio of stocks. Most advisers would suggest you consider mutual funds or exchange-traded funds as an alternative.
At present, Exxon Mobil is the top holding of the S&P 500, with Apple (NASDAQ:AAPL) a close second. Those same advisers might recommend a fund that replicates the performance of the index itself. Read on and we’ll recommend one ETF and one mutual fund that will accomplish this task.
A quick search reveals there are as many as 87 mutual funds and 103 ETFs that in some form replicate the performance of the S&P 500. To whittle that down to a manageable number, we’ll eliminate any fund that uses leverage or in some way deviates drastically from the index itself.
Furthermore, since the impetus for seeking out alternatives was Exxon Mobil stock, only those funds that hold the world’s largest oil company in the No. 1 spot will be considered.
Whenever you choose a mutual fund based on an index, cost is your primary concern. That’s because the fund manager does little except make sure the computer keeps the fund tracking the index. The absence of active management drives down the cost of operating the fund to a negligible amount. Therefore, any cost comparison between an ETF and a mutual fund (where both are based on the S&P 500) should be relatively close.
After rummaging through the product offerings of the top 20 fund families by retail net assets, the choice comes down to two companies: Vanguard and Fidelity. The expense ratio of the Fidelity Spartan 500 Index Fund (MUTF:FUSEX) is 0.1%. This compares with 0.17% for the Vanguard 500 Index Fund (MUTF:VFINX).
The second-most important criterion when comparing index funds is the tracking error. Generally, if the index achieves a total return in any given year of 10%, ideally you’d like to see your fund do the same. Unfortunately, that never happens, so you want to make sure the fund at least comes close over an extended period of time. During the past decade, the Fidelity fund tracked within 8 basis points of the index, compared to 11 bps for Vanguard — not a huge amount.
The big difference in the two funds is the minimum investment required. At Fidelity, it’s $10,000, whereas Vanguard’s minimum is much lower at $3,000. It really comes down to your personal situation. If you can afford the $10,000 investment, you should look at Fidelity; if not, go with Vanguard.
When buying an ETF that tracks the S&P 500, in addition to considering the expense ratio, it’s equally important to consider the bid/ask spread, which is the difference between what potential investors are willing to pay to buy an ETF unit and what existing investors are willing to accept to sell. Like stocks, funds that are thinly traded should be bought using limit orders to minimize the unintended additional costs that can occur through market orders.
Using both criterion, once again it comes down to personal preference. The country’s biggest ETF in the US is the SPDR S&P 500 ETF (NYSE:SPY), with total net assets of around $100 billion. Its average daily share volume is 199 million, which is five times the volume of XOM. Its expense ratio is 0.09% with a bid/ask spread on Jan. 26 of 0.02%. As a result, market orders shouldn’t be a concern.
However, the Vanguard S&P 500 ETF (NYSE:VOO) has an expense ratio that is two-thirds the SPY at 0.06%. Furthermore, although it does have a much bigger bid/ask spread (again, use a limit order), its tracking error to the index in 2011 was seven basis points compared to 25 bps for the SPY. Vanguard only created this ETF in September 2010, but so far it’s a winner. On this occasion, you might want to go with Vanguard.
If you are investing a single amount in a fund that tracks the S&P 500, it might make more sense to go with the Vanguard ETF. However, if you’re looking at dollar-cost averaging through an automatic investment plan and have the $10,000 initial deposit, Fidelity’s Spartan 500 Index Fund is a better choice.
As of this writing, Will Ashworth did not hold a position in any of the aforementioned securities.
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