Academic journal article Financial Services Review

Index Funds or ETFs: The Case of the S&P 500 for Individual Investors

Academic journal article Financial Services Review

Index Funds or ETFs: The Case of the S&P 500 for Individual Investors

Article excerpt


We investigate alternative S&P 500 indexing strategies for individual investors using S&P 500 index funds and the Standard and Poor's depository receipt (SPDR). This investigation is important because while SPDRs have lower advertised annual expenses, investors in SPDRs face bid-ask spreads and commissions. We compute average spreads of SPDRs using transaction-by-transaction data, present a model to illustrate how investors can compare alternative index investments, and illustrate the results under several scenarios. We conclude by comparing risk-adjusted returns of the alternatives to ensure that undisclosed trading costs do not alter the choice.

© 2009 Academy of Financial Services. All rights reserved.

JEL classifications: G12; G14; G15

Keywords: ETFs; S&P 500; Fees and expenses; Standard & Poor's depository receipts

1. Introduction

Empirical research on the performance of actively managed mutual funds suggests that they fail to consistently outperform the market on a risk-adjusted basis. Abundant studies find little evidence of market timing ability (e.g., Becker, Ferson, Myers, and Schill, 1999; Chang and Lewellen, 1984; Daniel, Grinblatt, Titman, and Wermers, 1997; Grinblatt and Titman, 1989, 1994; Henriksson, 1984; Kon, 1983; Lehmann and Modest, 1987; Treynor and Mazuy, 1966). Some studies even report evidence of perverse timing ability (e.g., Cumby and Glen, 1990; Viet and Cheney, 1982). Moreover, Gruber (1996) and Fortin and Michelson (1999, 2002) argue that the evidence is conclusive that actively managed funds under perform.

In 1976, the Vanguard Group launched the first S&P 500 index fund to provide a low-cost buy-and-hold alternative to active management. By mirroring the index, costs should be low because research expenses are eliminated, portfolio management requires fewer resources, and transactions costs (bid-ask spreads and commissions) are reduced. Moreover, given the emerging evidence at that time that portfolio managers incurred marginal costs in excess of the marginal returns they garnered, indexing appeared to be a better alternative to investors than investing in actively managed funds. Low cost indexing became increasingly popular with investors and by December 2006, 169 more S&P 500 index mutual funds were created by Vanguard's competitors. Thus, investors desiring to index all or parts of their portfolio to the S&P 500 have many mutual funds available from which to choose.

In 1993, State Street Bank & Trust Company introduced Standard & Poor's depository receipts (SPDRs) that track the S&P 500 index. The SPDR (ticker symbol SPY) is an Exchange Traded Fund (ETF) and is claimed to possess lower annual expenses than index funds. A competitor of the SPY is the iShares S&P 500 index (ticker symbol IVV) that was introduced in May 2000. However, the SPY is more popular, has more trading volume, and a longer return history. We concentrate on the SPY in this paper because the reported annual expenses of the SPY are lower than those of the IVV, thus, to the extent that these expenses represent relative costs of ownership, the SPY would be the superior investment. Unlike mutual funds, ETFs must be purchased through a broker; therefore, investors face brokerage fees to purchase and sell ETF shares. In addition, because trading ETFs is similar to trading shares of stock, ETFs are purchased at the dealer's ask price and sold at the dealer's bid price, which is lower than the ask price. Thus, ETFs resemble "load" mutual funds because load funds must be purchased at the public offering price [that is higher than net asset value (NAV)] and redeemed at NAV.

The dilemma facing investors who desire to implement an S&P 500 index strategy is whether index mutual funds or SPDRs are the better investment vehicles. Although SPDRs claim lower annual expenses, no-load index funds can be purchased and redeemed at NAV and have no trading costs. …

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