7 Myths About S&P 500 Index Funds

Share:

The S&P 500 Index is arguably the best known and most followed index of publicly traded companies. There are hundreds of S&P 500 index funds and exchange traded funds to chose from if you want an investment that tracks the S&P 500 Index. Since they all track the same index, these mutual funds and ETFs must all be alike, right? Wrong! The fact is that the returns of S&P 500 index funds can vary dramatically, and this is just one of seven myths about S&P 500 Index Funds you should know before investing.

Myth #1. S&P 500 Index Funds Invest in the 500 Largest Companies: The S&P 500 is comprised of large cap companies, but it is not just the largest 500 companies. Rather, the companies comprising the S&P 500 Index are selected by the S&P Index Committee comprised of Standard & Poor’s economists and index analysts. The goal is to create an index of leading companies in leading industries.

While the index includes many of the largest U.S. companies (e.g., Exxon and Microsoft), it does not include the 500 largest companies. One factor that can keep a company out of the index is insufficient liquidity (i.e., a company’s stock does not get bought and sold in sufficient quantity). A good example of this is Berkshire Hathaway, one of my favorite investments. With an A share costing more than $100,000, Berkshire’s lack of sufficient liquidity keeps it out of the index (I doubt Mr. Buffett loses any sleep over this fact).

Myth #2. S&P 500 Index Funds Own U.S. Companies Only: There is a bit of history here. In the early 1990′s, the S&P Index Committee announced that it would no longer add non-U.S. companies to the index. At that time there were a handful of foreign corporations, and the committee made clear that they would not remove existing foreign companies from the index just because they were foreign companies. By about 2000, the index was down to seven non-U.S. companies, and today all of the companies that form the S&P 500 index are considered U.S. companies by the committee.

However, many of the U.S. companies that comprise the index have substantial international operations. These companies conduct business and hold assets denominated in foreign currencies. Their foreign operations are subject to non-U.S. laws and can be negatively impacted by political unrest, particularly in emerging markets and frontier markets. The point is that an investment in an S&P 500 index fund creates some international exposure to your portfolio. This isn’t a bad thing, in my opinion, just worth noting.

Myth #3. S&P 500 Index Funds Own Equal Amounts of 500 Companies

Most S&P 500 index funds are what is called market capitalized weighted. What this means is that the fund does not invest the same amount in each of the 500 companies that comprise the index. Instead, it invests an amount in each company that is proportional to the market capitalization of that company. The market capitalization is simply the value of all shares owned by the public.

What this means is that a market capitalized weighted fund invests a lot more in Exxon (the largest company in the S&P 500 based on market capitalization), then it invests in the 500th largest company on the S&P 500.

There are funds that invest equal amounts in each of the 500 companies comprising the S&P 500. An example of such a fund is the Rydex S&P Equal Weight (RSP) exchange traded fund. The difference here is that more of the fund�s investments are put into relatively smaller companies.

So which is the better investment? There really is no �better�; each fund has a different investing objective. Most S&P 500 funds are market weighted. The more important point is simply to understand that there is a difference so that you can make an informed investing decision. I will say though that one key reason to invest in an index fund is to mimic the market, and an equal weighted index fund does not accomplish this goal.

Myth #4. S&P 500 Index Funds have Low Expense Ratios: While many S&P 500 index funds do have low expenses ratios, many do not. The DWS S&P 500 Index C (SXPCX) fund, for example, has an expense ratio of 1.4%. Why would you pay so much for an index fund, you ask? You wouldn’t, or at least you shouldn’t. The Vanguard S&P 500 index fund (VFINX) costs just 0.15% per year, and Fidelity’s Spartan U.S. Equity Index (FUSEX) fund, which I own, costs just 0.09%.

Some S&P 500 funds even come with front loads or deferred loads, which is really insane.

Myth #5. S&P 500 Index Funds are the Only Type of Index Mutual Fund: The S&P 500 index is so well known that I’ve talked to folks who think all index mutual funds track the S&P 500. The fact is there are many domestic and foreign indexes that are tracked by mutual funds and ETFs. One good website for researching such finds in Index Universe.

Myth #6. All S&P 500 Index Funds Have the Same Returns: This is a really important point to take note of. The returns of S&P 500 index funds can vary dramatically. This is due in part to variance in expense ratios noted above. In addition, some index funds spend more money buying and selling stock than others. Based on Morningstar’s fund screener, S&P 500 index funds’ returns for this year have ranged from a low of about -14% to about -12%. And if you think 2 percentage points is not much, you should read how even 0.5% can ruin your retirement.

Myth $7: An S&P 500 Index Fund is Enough for a Well Diversified Investment Portfolio: An S&P 500 index fund is diversified within the context of U.S. equities. But there are many important asset classes that are not represented in this index. For example, the S&P 500 does not include bonds or other fixed income securities. It does not include small cap companies, foreign companies, REITs, or commodities. As noted above with respect to foreign companies, the S&P 500 index does have some exposure to these asset classes, but not enough to create a well diversified portfolio. So while an S&P 500 index fund can be an important part of a diversified portfolio, investments in other asset classes is important.

An S&P 500 index fund is, in my opinion, a great way to start investing. If I were just starting off today, it would be one of my first investments. Over the long run, the S&P 500 beats most actively managed mutual funds. But it is important to make sure you are investing in a low cost, well managed fund, because not all index funds are created equal.

Published or Updated: March 30, 2012
About Rob Berger

Rob founded the Dough Roller in 2007. A litigation attorney in the securities industry, he lives in Northern Virginia with his wife, their two teenagers, and the family mascot, a shih tzu named Sophie.

Comments

  1. Randy says:

    Nice article. Instead of an index fund, some people might be better served by purchasing an equivalent ETF. Why? Mostly for tax-efficiency.

    Since index and mutual funds are pooled assets, a manager may be forced to liquidate a portion of the invested assets if a large number of investors decide that they want to cash in their fund. This can cause the fund to trigger short-term capital gains for all investors of the fund.

    ETFs on the other hand, are created on-demand for a single investor. As such, the risk of inadvertently incurring short-term gains is minimized.

    Best,
    Randy

  2. James says:

    Great article. This is a good resource to help people know exactly what they’re investing in.

  3. Early Retirement Extreme says:

    Nice article. In combining myth 3 and 4, it suggests just buying the 10-15 largest market cap companies to get a zero fee portfolio that is effectively as diversified at the entire index.

    However, I think most people buy index funds because it is easy and following the herd makes them comfortable. I just hope the herd does not get too big.

  4. Mo Money says:

    This is good. For some one just learning to invest this is great. It is informative and it covers many of the issues facing the investor. Thank you!

  5. I enjoyed this article a lot. I used to have the S&P as my main index fund but no longer. I own the Total Stock market index instead, which is a better representation of the U.S. stock market based on weightings in its portfolio (it’s a better U.S. benchmark than the S&P). But employers usually have the S&P index in their retirement plans because that’s what people are most familiar with.

  6. StockStudent says:

    This is a great article. I also like your other posts on your blog. I have subscribed and look forward to reading more!

Speak Your Mind

*