Without having a specific reference, I would argue that the S&P 500 Index is probably the most important equity index in the world. As we all know, the index consists of America’s largest 500 public companies (fun fact: there are currently 503 constituents, not 500) and covers about 80% of the available market capitalization (S&P Dow Jones Indices, 2023).
For many investors, an ETF that tracks the S&P 500 became synonymous with passive investing. In this article, I will challenge this statement and analyze if the S&P 500 is indeed passive. I will also compare the three largest ETFs that track the index. I think the start of the year is a good time to address such questions and maybe consider them in rebalancing decisions.
ETFs on the S&P 500: SPY vs. IVV vs. VOO
The three largest ETFs that track the index are the SPDR S&P 500 ETF Trust (SPY), the iShares Core S&P 500 ETF (IVV), and the Vanguard S&P 500 ETF (NYSEARCA:VOO). These ETFs collectively command an unbelievable $1.44T of assets. With about $790B, VOO is by far the largest of the three.
Let’s start with a simple comparison. All ETFs have the same goal: tracking the S&P 500 Index as close as possible. The chart below summarizes the results for the longest common period between 2010 and 2022.
The shaded blue area is the S&P 500 Net Total Return Index. It is important to use this variant of the index because the headline S&P 500 is a price index that does not consider dividends. The first important observation is that all ETFs are very close to the benchmark (it is the purpose of the chart to show that there is essentially just one line…). Cumulative return differences are within the range of 3 percentage points over more than 10 years. I think this is negligible and, in my opinion, all ETFs met their target sufficiently well.
However, when we compare SPY, IVV, and VOO, the performance of SPY stands out. The fund trails both others by 1.9 percentage points (215.5% vs. 217.4%). Again, this is not much over this >10-year period, but it appears to be systematic. Also note that while it is probably negligible for you and me, it is quite some money in aggregate. Over the last 10 years, the average assets under management for SPY were about $250B. A cumulative tracking difference of 1.9%-points to the other two ETFs therefore amounts to $4.75B in lost performance. If you play with giant sums, small things matter.
To offer a potential explanation for the performance difference, the next chart summarizes the current expense ratios of the three funds.
While the expense ratio for VOO and IVV both stand at an extremely low 0.03%, SPY is more than three times as expensive (0.0945%). This certainly explains some of the difference. However, I want to highlight that investors should not just look at expense ratios when evaluating ETFs. Fees are obviously very important, but ultimately, after-fee performance matters. Sometimes there are ETFs with higher expense ratios but better tracking methodology that are worth their fees. I rather pay 0.1% for an ETF that tracks the index perfectly than 0.05% for one that lags it by some basis points per year.
For the SPY, however, this is not the case. The ETF is more expensive than the peers and has a larger tracking difference. So, based on this little analysis, I would personally prefer VOO or IVV to invest in the S&P 500. So let’s see who is the better one of these two.
IVV vs. VOO – BlackRock vs. Vanguard
After eliminating SPY from the contest, it is now a competition between even more similar products. To be honest, I believe it ultimately doesn’t matter with respect to the product. Both funds are very cheap (3 basis points), have tremendous scale (>$100B AuM), and historically tracked the index very well. The following chart supports this argument and shows that the annual returns of the two indices were basically identical.
So who is the winner? In my opinion, this becomes a question of BlackRock versus Vanguard. Both managers are obviously outstandingly professional and among the best you can get. However, when it comes to index funds, I personally prefer Vanguard. BlackRock is a publicly listed asset manager who does a lot of other things aside index funds. Vanguard, in contrast, is this special organisation built to deliver cheap market exposure for the average investor. For the purpose of indexing, I think this is just the better fit. But as I mentioned, this is just my personal opinion and not meant to be hostile against BlackRock (I hold iShares ETFs myself). Apart from that, VOO is with almost $790B AuM considerably larger than IVV ($289B). Given that nothing is more important for index funds than scale, this could be an advantage at some points.
Bottom line: if I would have to make an investment in the S&P 500, I would use VOO. But the differences are really minor and (depending on your assets) there is probably no material reason to shift from one of the others. In the end, index funds are commodities. Some managers may have a slightly better methodology than others, but in the end, it is more important that you find a product/manager you feel comfortable with for the long-term.
Is the S&P 500 Truly Passive?
As I mentioned in the introduction, investing in an S&P 500 ETF became for many investors synonymous with passive investing. Let me give you the important message upfront: this is dead-wrong. The S&P 500 is actually a quite active strategy when compared to the theoretical idea behind passive investing. But let me explain.
The idea of passive investing comes from academia. More specifically, from Markowitz’ portfolio theory, Tobin’s two-fund separation, and the Capital Asset Pricing Model (CAPM). Apart from that, countless empirical studies documented poor results from active management. Together with Sharpe’s famous Arithmetic of Active Management, the idea that active managers in aggregate must underperform by the amount of fees they charge, there is now compelling evidence for passive investing and the investment industry changed accordingly.
Going into more details about the academic origins is beyond the scope of this article (you can find more about that in my blog), so let me give you the clean definition of passive investing: passive investing means holding the market portfolio. That is the portfolio of all risky assets, where each position is weighted by its market value. This means all stocks, bonds, real estate, currencies, cryptos, private equity, etc. – everything.
This theoretical ideal is of course unrealistic (researches still tried to come up with a market portfolio benchmark) and not achievable for most investors. So for the purpose of this article, let’s ignore other asset classes than stocks. To be a passive investor, you must hold a market-cap weighted portfolio of all stocks in the world. Practically, this is something like the MSCI ACWI Index (for example via ACWI) or the FTSE All-World Index (for example, via a cap-weighted combination of VTI and VEU).
This simple fact is the reason why a part of me dies whenever I hear people equating the S&P 500 with passive investing. The MSCI ACWI IMI Index, one of the broadest practical benchmarks available, currently has 9,220 constituents from 23 Developed and 24 Emerging Markets. With the S&P 500 you bet on 500 large caps from the US. This is not passive investing. Even in terms of market value, the US contributes just 60.7% to this index.
Now, I don’t write this to bash the S&P 500 or to tell you that it’s bad to invest in it. Even though it ignores small and mid caps, the S&P 500 is a reasonable passive benchmark within the US (because of the market-cap weighting, long-term returns on the S&P 500 and broader benchmarks like the Russell 3000 are fairly close). From a global perspective, however, the S&P 500 is an active bet on US large caps. Historically, this was a good bet. The US outperformed the rest of the world for most of the last 15 years. But there is no guarantee that this will continue, and only true passive investors don’t care about outperformance of one country or another. Because by definition, they hold everything.