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The SPY ETF Proves Simpler Is Often Better

The SPDR S&P 500 ETF (NYSEARCA:SPY) is often highlighted for its status as the world’s largest exchange-traded fund, but the SPY ETF has more to offer besides heft. At a time when some fund options are increasingly complicated, SPY’s simplicity stands out.

A traffic light flashes green in front of Wall Street.

Source: Shutterstock

Let’s start with the basics. The SPY ETF comes with a modest fee of 0.0945% per year, or $9.45 on a $10,000 investment. As its name implies, it follows the S&P 500 — one of the world’s most widely observed equity benchmarks.

To be precise, SPY holds 505 stocks, owing to multiple share classes for constituents such as Alphabet (NASDAQ:GOOG, NASDAQ:GOOGL), Berkshire Hathaway (NYSE:BRK.A, NYSE:BRK.B) and a few others.

The S&P 500 is weighted by market capitalization, meaning the largest U.S.-based company by market value, currently Microsoft (NASDAQ:MSFT), is the largest component. Then it goes Apple (NASDAQ:AAPL), Amazon (NASDAQ:AMZN) and so on down the line. Due to the ascent of Microsoft, Apple, Amazon and Alphabet into the $1-trillion club, SPY’s top 10 holdings combine for roughly 29% of the fund’s weight.

That’s near historical highs for the S&P 500.

All About Market Cap Weighting

As the ETF industry has evolved, so has the way index providers weight equities within benchmarks. Now investors can get their hands on hundreds of ETFs that employ weighting methodologies such as equal weight, weighting by factors such as growth or value, and dividend yield. Some indices go even further, scoring stocks based on profitability, cash flow or management-related criteria.

The selling point for many of these ETFs was borne out of the criticism of market capitalization weighting. Market cap weighting itself was largely borne out of the tech bubble of 2020. Critics assert that while cap weighting does represent the market’s collective wisdom, the strategy can also lead late investors into overvalued stocks.

Another frequently levied critique of cap-weighted strategies is that investors miss out on the benefits of the small size factor. Though more volatile, small-cap equities offer better rates of growth and historically outpace large-caps over long holding periods.

“Companies with smaller relative market caps, particularly firms that are of higher quality, have historically been associated with returns that beat a broad market index,” according to Morningstar.

Is SPY’s Mega-Cap Status So Bad?

The SPY isn’t just a large-cap fund. It’s well into mega-cap territory —  the weighted average market value of its holdings is $409 billion.

That’s not a knock on the SPY ETF. Rather, it’s worth noting that cap-weighted indices and their corresponding funds are usually cost-efficient. Because of this, they’re harder to beat.

“Market efficiency is often cited as a big reason why market-cap-weighted indexes, and low-cost funds that track them, are so notoriously difficult to beat. Any stock’s price, and its corresponding weight, should incorporate all known information — including its current value and expected return — limiting the chance that anyone can gain an advantage.”

How does this translate to SPY’s performance? Say the S&P 500 jumps 20% in a given year. That 20% will be the return SPY investors get, minus the fund’s annual fee.

The Bottom Line on the SPY ETF

Like any fund that weights stocks by market capitalization, SPY is reactive. This means the weights assigned to rising stocks increase after the stock price increases. Conversely, faltering stocks are assigned lower weights as they decline, not in advance of that downside.

So SPY isn’t predictive. Not much in equity markets is. Still, the ETF does an efficient job of highlighting what’s working today in equity markets. For example, technology stocks represent 27.5% of the fund’s weight because investors have long favored that sector. On the other hand, financials are struggling this year. The sector entered 2020 as the third-largest exposure in SPY, but has since been relegated to the fifth spot.

For alpha-hungry investors, augment a stake in SPY with growthier or riskier fare. However, for new investors or those that don’t want to do a lot of leg work, the fund is a sensible option as a cornerstone portfolio holding.

Todd Shriber has been an InvestorPlace contributor since 2014. As of this writing, he did not hold a position in any of the aforementioned securities.

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