The SPDR S&P 500 ETF Trust (NYSEARCA:SPY) has suffered losses in 2022, but so has the broader U.S. stock market. Despite the recent pain, the exchange-traded fund is a smart and effective way to take advantage of investing in all the largest 500 U.S. public companies at a fraction of the total cost. However, there are admittedly a few cons to investing the SPY ETF too.
With that in mind, let’s take a closer look at whether the SPY is the right move for you.
Before you consider investing in the SPY ETF you should consider a few things. First, how good of a stock picker do you consider yourself? Second, do you like passive investing instead of active investing?
I’ll expand upon these questions in a moment, but it’s also important to note something about the S&P 500 Index that the SPY is based on too.
The S&P 500 Index features the 500 largest U.S. publicly traded companies, and is a capitalization-weighted index, meaning companies with a larger market capitalization have a much greater impact on the index value than smaller companies. The index uses the free-float factor to adjust calculations.
As such, the largest U.S publicly traded company, Apple (NASDAQ:AAPL), has the largest weight of 7.05% in SPY ETF as of Feb. 7. Microsoft (NASDAQ:MSFT) has the second-highest weight at 6.03%. Amazon (NASDAQ:AMZN) has the third-largest weight of 3.61%.
Critics of market capitalization indexes argue that there could be a distortion in the index as large companies have a lot of influence. In underperforming years, they could drag the indexes down, while smaller companies may outperform. Overall, these indexes would not reflect the “true” financial performance of the market. There is a lot of sense to this argument; however, we must accept the way the SPY works if we’re considering it a buy.
SPY ETF: The Good Factors
Investors in SPY ETF get exposure to the 500 leading U.S. companies, which also means they get plenty of diversification. For example, this means exposure ranging from the information technology sector (28% of the SPY ETF’s holdings fall within this sector), all the way to the healthcare sector (the SPY’s second-largest weight, comprising 13.18% of the fund).
Besides diversification, there are many other benefits of investing in an ETF. These include trading similarities with stocks, lower fees than mutual funds and tax efficiency. They can also be a smart and efficient way to replicate the performance of a large index, such as the S&P 500, with a relatively small cost.
The SPY ETF is 10% of the S&P 500 index, so with $450 investors get exposure to all 500 stocks of the index. This is a great concept with massive utility. In addition, transaction costs are low and liquidity in the SPY ETF is great.
Returning to my first question — “how good of a stock picker are you?” — the S&P 500 index serves as the barometer of the U.S stock market. Imagine that even if you bought one share of each 500 company in the S&P index you would have to invest a lot of money. A comparison with the performance of the S&P 500 index with your portfolio would be unfair unless you followed the same weights exactly used for the methodology of calculating the index. This would be a very tough challenge. The SPY removes that challenge.
One ‘Bad’ Factor to Consider
My second question in the beginning, was about whether you like passive or active investing. The following two charts give insight into why I asked this question.
First, a comparison of the five-year performance of the SPY against the top six largest companies by weight in the SPY.
Now, let’s take a look at the year-to-date performance of the SPY ETF compared to the same six companies.
On a year-to-date basis, investors investing in the majority of these six stocks have incurred larger losses than investing in the SPY ETF. But compare the five-year performance of these stocks to the SPY ETF, and you’ll see that you have left many gains on the table.
This embodies how the stock market works. You must weigh the risks, potential returns and time you have to make stock picks on your own. More finesse and time spent making choices (through active investing) can lead to greater gains, but with that comes a good amount of potential risk as well.
Ultimately, whether this degree of safety in the SPY is “bad” largely depends on your investing philosophy and goals.
The Ugly
What if the selloff in the S&P 500 continues in 2022 with higher interest rates around the corner? After a very strong 2021, the S&P 500 now trades at a price-to-sales ratio of 2.99x, which stands near its highest level since 2010.
Moreover, the current price-to-book value of the S&P 500 (4.59x) is very close to the highest level dated back in 2000. The Shiller P/E ratio of 37.24x, which adjusts for average inflation-adjusted earnings from the previous 10 years, is also highly elevated.
Circling back to the largest-weighted sector in SPY ETF (the Information Technology sector), 2022 will probably be nothing near as great for these stocks compared to 2021. Tech stocks should be under pressure this year due to elevated prices and natural valuation concerns.
Bottom Line on the SPY ETF
This ETF is ideal for long-term investors who do not wish to actively trade, invest or pick stocks on their own.
ETFs are also subject to price swings and the SPY ETF is no exception. The S&P 500 may have a tough year ahead in 2022, but still, individual stocks may decline more than the index. This adds an element of safety, as no one loves losses, but they are an inevitable part of investing.
On the date of publication, Stavros Georgiadis, CFA did not have (either directly or indirectly) any positions in the securities mentioned in this article. The opinions expressed in this article are those of the writer, subject to the InvestorPlace.com Publishing Guidelines.
Stavros Georgiadis is a CFA charter holder, an Equity Research Analyst, and an Economist. He focuses on U.S. stocks and has his own stock market blog at thestockmarketontheinternet.com/. He has written in the past various articles for other publications and can be reached on Twitter and on LinkedIn.
