After the decision to invest in the ever popular market benchmark, S&P 500, investors have two options within the ETF universe for a pure play S&P 500 option, iShares IVV and the SPDR, SPY. It seems that investors have made up their minds but is this decision optimal and which S&P 500 ETF is best suited for which kind of investor?
Structure is Everything
The SPDR fund, SPY, is the oldest and most traded ETF in the US. When ETFs were first being created they all were Unit Investment Trusts (UITs). UITs are structured in a way that the investors of the fund actually can redeem the underlying holdings; however for an ETF redeeming the underlying securities is reserved for market makers and is prohibited to individual investors. The units can only be created and redeemed in units of 50,000.
ETFs filed as UITs are held in trust and units of the trust are sold and traded. SSgA is the trustee of the fund. What is notable about the fund is that SPY sells at 1/10 the index price. Most of the other features of an UIT can be inferred from this fact. The UIT manager is limited in most ways where other ETF managers have leeway or freedom. The manager must fully replicate the underlying index at all times. The manager cannot lend shares as a way to generate revenue. Dividends must be held in cash and paid at the time when the fund distributes them. All Fund Expenses are paid from the dividends earned by the underlying holdings. The UIT structure was slightly changed for ETFs. Non-ETF UITs have a predetermined end whereas the UIT ETFs do not have an end or are continuously rolled.
This ETF structure is limited and advantageous for different purposes making it more suitable for some and less suitable to others. Because SPY’s net asset value (NAV) always very closely mimics the S&P 500 index it is very reliable and suitable for derivatives trading. Without this strict structure prices may vary slightly without warning even if mostly favorable for the long investor, which may disrupt an option strategy. In the same way any strategy depending on the ETF tracking very closely to 1/10 the S&P 500 should rely on SPY. Because of that reason SPY is a favorite, relative to IVV for intraday trading. Traders and strategy investors demand no surprises other than what is reflected by the underlying stocks or trading on the ETF. In the same way, short term investors are not as concerned with small price differences.
The limitation of SPY is this; SPY reflects 1/10 of the S&P 500 Price Return Index. Meaning that as dividends are earned from the underlying equities SPY holds them in cash until they are paid out quarterly. Since dividends cannot be reinvested, a ‘dividend drag’ is created where during climbing markets dividends add to the return of an ETF while during descending market periods, the UIT, holding the dividends in cash is more profitable.
The open-end structure of IVV gives the portfolio manager more freedom. For instance, IVV can loan shares and receive interest. IVV is not required to hold all 500 of the underlying stocks in the index, although it usually does and can use an optimization approach to best represent the index. All these freedoms can allow IVV to reduce the cost of operation to investors. The most important difference between IVV from SPY is that as dividends are earned by the underlying equities, IVV reinvest them into the index until they are to be paid out quarterly.
From a buy and hold investment strategy, the difference between SPY and IVV is clear; over the long run an investor deciding to invest in the S&P 500 is better served by having their dividends invested in the ETF, not cash, until they are distributed quarterly. This difference is slight and any advantage IVV has can be lost by higher expense ratios. Since 2000 Barclays and State Street has competed for assets and continually lower expense ratios. This competition has made the two ETFs some of the lowest costing funds available. Today, SPY has the lower expense ratio at .08% and IVV closely trails at .09%. However SSgA writes in small print on the SPY section of their website that they have, “agreed to waive a portion of its fee until February 1, 2009, but may thereafter discontinue this voluntary waiver policy.”
– Casey Smith is the President of Wiser Wealth Management