Tuesday, 2 March 2010

ETF Comparison: USA S&P 500 or Similar Equity Index Funds

The S&P 500 Index is a well-known and widely-reported indicator of the state of the equity market in the USA. The index comprises the 500 largest and most actively traded companies in the USA. The 500 companies are deliberately chosen to represent all sectors of the economy and they make up about 80% of the total market value of all US equities.

A Canadian investor has several good reasons to invest in the US equity market and in the S&P 500:
  • diversification from the relatively restricted range of the heavily financial and resource-based companies of the Canadian equity market into sectors more prevalent in the USA, such as manufacturing, health care and consumer goods
  • diversification into a much larger number of companies in a market which has historically provided very good returns (US equities provided a 6.2% annual real return between 1900 and 2009 vs 5.8% for Canadian equities in the same period according to the Credit Suisse Global Investment Returns Yearbook 2010)
ETFs provide a very convenient and cost effective way to invest in the S&P 500, with both US-traded and TSX-traded versions being available online through discount brokers. There are also similar indices and ETFs other than those that track the S&P 500, providing the investor a wide choice. All the ETFs below share the feature of passively tracking US large cap stocks (i.e. merely mimicking the market and not trying to outperform in any way or by any means) that make up the bulk of the equity market.

S&P 500 Trackers
  • SPDR S&P 500 (symbol: SPY) - a long established ETF, it is the monster fund in terms of net assets, in fact the biggest ETF in the world by far, which means the best liquidity and lowest bid-ask spreads
  • iShares S&P 500 (IVV) - another massive fund and very little to distinguish it from SPY
Other Large Cap Funds - these three funds include 250 or so more companies, which has two effects:
1) lowers the size of the companies held from about $43 billion average market cap to $37 billion
2) slightly reduces the concentration of holdings from over 19% made up by the top ten holdings to 18%.
  • Vanguard Large Cap ETF (VV) - the largest of the second tier funds but is much smaller than the S&P 500 heavyweights
  • Schwab US Large Cap ETF (SCHX) - very new entrant founded only in November 2009 but has attracted sizeable assets in a short time
  • SPDR Dow Jones Wilshire Large Cap ETF (ELR) - around since 2005 but has not caught on in a big way
Canadian-Traded ETFs - both these funds attempt to remove the effect of currency swings between the Canadian and US dollars through hedging and to provide the performance of US equities to Canadian investors
  • iShares CDN S&P 500 Index (hedged to Canadian dollar; symbol: XSP) - holds IVV and adds hedging, a very large fund by Canadian standards
  • BMO US Equity Index ETF (hedged to CAD; symbol: ZUE) - tracks an index of 729 companies but only holds a sample of 244 stocks, no doubt due to the small size of the asset base built up since the May 2009 launch
Comparison Tables
  • US-Traded ETFs

  • Canadian-Traded ETFs

Which ETFs are the Winners?
It is hard to pick a best fund since several are so similar. SPY, IVV, VV are all excellent funds with very low costs (Expense Ratio, Bid/Ask spread, Premium/Discount to NAV) and close tracking of their index (see image of Google Finance chart below - it is hard to tell the lines apart from each other and from the S&P 500 index itself).

SCHX appears to be heading to join the top group if it continues to attract assets and build trading volumes to lower the bid/ask spread. ELR has a much higher expense ratio and too low trading volumes, shown by the red cells in the table.

The Canadian entrants suffer a lot from the burden of hedging, which seems to lower net returns not only by the expected supplementary direct cost of the hedging but also through much less effective tracking of the index. Larry MacDonald describes the issue in Check the Tracking Error Margin for Currency ETFs on Seeking Alpha. The chronic and seemingly ever-widening gap in the Google Finance chart below between XSP and IVV, the US fund whose performance it attempts to clone, illustrates the problem.

However, currency effects can far outweigh the tracking under-performance so a hedged fund may still make sense (see previous posts The Historical Effect of Inflation and Currency on an Investor's International Portfolio and Foreign Investments: to Hedge or Not to Hedge Currency). Canadian investors may thus still want to buy XSP or ZUE.

Disclaimer: this post is my opinion only and should not be construed as investment advice. Readers should be aware that the above comparisons are not an investment recommendation. They rest on other sources, whose accuracy is not guaranteed and the article may not interpret such results correctly. Do your homework before making any decisions and consider consulting a professional advisor.

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