Episode Transcript
Brenton: [00:00:00] When it comes to investing, index funds are some of the most cost effective tools you can use. And across the country, many investors feel they are the only thing you need to put your money in to be okay financially.
In this episode, we talk about a particular index called the S&P 500. How the index funds that track them aren't all created equally, and whether to know whether it's even the right option for you to use in your portfolio. Let's get started.
[00:01:00]
Brenton: Hello, this is Brenton Harrison of New Money, New Problems, and your host for the New Money, New Problems podcast. In our recent episode, we covered the pyramid of investments and we talked about, based on how conservative or aggressive an investment is or how prepared you are financially, you can choose different investments from that pyramid to place them in your portfolio. In that conversation we talked about briefly index funds and exchange traded funds. And I wanted to dig a little deeper into those funds in this episode. You see index funds are a mutual fund or exchange traded fund that, instead of having a manager or managers that you're paying to make purchasing decisions throughout the year, they are choosing to track a sector or a segment of the market.
Now the S&P is seen as a really good indicator of how the broader market is doing. Because since you're dealing with the 500 biggest companies in the US stock market, their comings and goings have a lot to do with the economy's comings and goings as well. As a [00:02:00] matter of fact, the 500 companies in the S&P actually represent in terms of the total cash that they have, over 80% of the entire stock market. So it's a really broad range of companies and they are so big that they hold a lot of the dollars that are on the total stock market itself.
And based on what you're looking for, you can find a different collection of companies and the type of index you find when you dig into the details, you'll find a bunch of different factors that weigh into not just the companies that comprise it, but also how the impact of the different companies in that index is determined. You see there are some indices that are price weighted, and what that means is they put all the companies that are in the index and they look at the price of a share of their common stock. And based on the price of that stock, the ones with the highest price have the biggest impact on the index, even if they're not necessarily the biggest companies in the index in terms of the size or the amount of cash they have on hand. [00:03:00] The S&P 500 is what's called a market cap weighted index, and that's playing off a term called market capitalization. So let's cover what that means. Market capitalization is a tool that's used to measure how big a company is, and you find a company's market cap by taking their share price of their stock and multiplying it by the number of shares that are outstanding.
When you have a market cap weighted index, the companies with the largest market capitalization have a much larger impact and influence on how the index is performing than what you find in the smaller companies, even though they are still big in and of themselves. For example, when you look at the top 10 companies in terms of market capitalization in the S&P 500, their weighting is typically over 25% of the S&P 500.
So while there are 500 companies in the index itself, those top 10 in terms of their market cap probably have a bigger impact than what you find in the bottom 100 combined, because this is how the weighting of an index can [00:04:00] affect its performance.
For example, there's a group of companies that are affectionately known as FAANG, F A A N G. That's Facebook, Amazon, apple, Netflix, and Google whose parent company is Alphabet. And those are all tech companies and they all exist in the S&P 500. So even though the other 495 companies in the index may be doing really well, because of the weighting of just these five, poor performance and volatility in that space could lead to negative or volatile returns in the S&P, even though it's a small slice in terms of the number of companies that exist in that index.
And when you talk about the performance of companies and their market weighting in the index, you can't measure all 500 companies and change the weighting in the S&P 500 every single day.
So instead, what they do is they assess it quarterly and they rebalance the weighting of the S&P 500 based on the quarterly earnings and results of each of the companies in the index. So if you have a [00:05:00] company who is performing poorly, but it's still one of the 500 biggest, it may stay in the S&P 500, but the committee may change its weighting in terms of the impact on the overall index. Whereas you might have a company that performs so poorly that it not only falls out of the index, but the committee that governs the S&P chooses a replacement to be a part of that 500 for the upcoming quarter.
Now, all of these are the factors that govern how the S&P 500 works. But when you have an index fund that tracks the S&P 500, then you either have a mutual fund or an exchange traded fund that, in most cases, is doing the best it can to simply mirror the results of whatever that index returns.
And I say most of the time, because it would seem like if you have a bunch of index funds or exchange traded funds that are simply seeking to mirror the returns of the S&P 500, that they would all have the same return at the end of the year. But that's not how it works. That's not always what happens.
And believe it or not, that's not always even the [00:06:00] objective of S&P 500 funds. And after the break, we'll tell you how not all index funds are created equally, and how the S&P 500 may or may not be the index that you should be choosing to mirror in the first place.
[00:07:00]
Brenton: Before the break, we alluded to some of the differences that you see when it comes to S&P 500 index funds, and one of the first differences has to do with whether it is an exchange traded fund or a mutual fund. In our last episode, we talked about how with the mutual fund, you cannot buy into or sell out of that fund during trading hours.
You have to wait until the market closes for that trade to settle. The same is true for the price of mutual funds. Just like a stock, a mutual fund has a share price, but the share price of these funds is not altered during trading hours. It is set after the market closes. Well, with exchange traded funds, you can trade these funds [00:08:00] and the price of that ETF can rise or fall throughout the day. And when you compare what each investor paid, it may be different. So while both funds are technically tracking the S&P 500, the price that the investor pays, which has to do with the performance that they get in later years, can change based on whether they bought a mutual fund or an exchange traded fund.
The second factor influencing the return of an index fund are the fees that you pay. And I'm gonna separate this into two different types of fees, the first of which would be an expense ratio. An expense ratio is what you are actually paying the company that holds the fund to monitor, or in this case, track the investment itself.
And with an S&P 500 index fund, whether it's a mutual fund or an exchange traded fund, the fee, the expense ratio, should be pretty low, because there's not a lot of active management. They're just setting up computers and trying to mirror the return of the S&P 500. But that doesn't mean that all of the expense ratios are equal. There are companies out there that [00:09:00] charge a lower or higher fee than their competitors. And if you're tracking the same companies, but one fund is charging more than their competitor, it would make sense that at the end of the year they would have a lower return because their investors have more of their money being siphoned off to pay the expense ratio.
As a matter of fact, if you're following along with us on screen, you are looking at what's called a fact sheet, which is almost like a summary of different investments that you can find for mutual funds or ETFs. And we're looking at a fact sheet, when we put this in the show notes along with its prospectus, for the Vanguard S&P 500 exchange traded fund. And if you look on the first page, you'll see a section that says expense ratio. And the expense ratio for this fund is 0.03%.
Further down on this sheet, there's a table that compares the return of the S&P 500 going back to September 7th, 2010 to the return of the fund itself. And when you look at this, since that period of time, the S&P 500 has returned 13.34%, [00:10:00] and the fund itself has returned 13.3%. So essentially it's returned the same as the S&P 500, minus that 0.03% expense ratio that you pay for participating in this fund. Now, I say essentially because it's not exactly the same, and we'll come back to that in a second, but the next part of the fee conversation has to do with what you're either paying to an advisor who helped you enter into this fee. Or even to the company itself, to market the fund to other investors. That sounds crazy, but there's a type of fee called a 12b1 fee. And part of what you're paying in that fee is giving money back to the company, to market it to other investors. There are also commissions that you can sometimes pay to advisors. And in some cases, you pay a fee to that advisor at the end of every single year, which is called a back end load. And in other cases, you pay a larger commission on the front end for any new dollars that enter the investment, called a front end load.
So [00:11:00] when comparing one index fund to another, you not only have to look at its expense ratio, you also have to look at its load to determine how much of the money you put in is actually going into the investment itself.
The next factor in evaluating an index fund has to do with something called tracking errors, and that may or may not be what we were looking at in the example, where you saw the S&P 500, which returned 13.34%, and our fund returned 13.3%. So there's a 0.04% gap there, but our expense ratio was only 0.03%. That may be the result of a tracking error. And what happens with the tracking error is you have these funds who are trying to put together a basket of securities that not only matches the S&P 500 in terms of the companies involved, but also it's weighting. And they have to determine this every single quarter and set it up appropriately, and they don't always do it correctly.
And when you see the return of the S&P 500 outperforming that of an index [00:12:00] fund in a way that surpasses what you're paying in an expense ratio, it may simply be the result of a tracking error, where when the fund was trying to replicate the makeup, not only in terms of the companies, but also the weighting in the S&P 500, they did it wrong, and as a result, the returns that you received are not as closely aligned with that of the S&P.
And then lastly, the performance objective of the fund itself. Just because a fund has S&P 500 in its name does not mean that it's objective is to track those 500 companies directly. As an example, if you're looking at the fact sheet on the screen, you'll see that there's a section on this sheet called Investment Approach, and under the investment approach is a bullet pointed list from this Vanguard Fund that says it seeks to track the performance of the S&P 500 index, and it says it employs a passively managed, full replication strategy. Meaning that they are not trying to invest part and parcel of the S&P 500. They are trying to track [00:13:00] it in full. But believe it or not, there are S&P 500 companies that only track portions of the S&P 500.
There are also companies who use the same 500 companies in the index, but not the same weighting system that you find in the S&P 500. There are those who have what's called leveraged index funds, where they're trying to outperform the S&P 500. They're even what's called inverse index funds, where they're trying to give you the opposite return of the S&P 500.
So if it performed negative five, They're trying to give you a positive five. So you have to make sure that when you're evaluating, you're not just assuming that because you're tracking the S&P or you think you're tracking the S&P that you're doing the right thing. You have to actually look at these fact sheets.
You have to go through the objective of the fund, how it's tracking to make sure, because there are some funds that outperform others, and there are also some whose objectives may not line up with those of your portfolio.
So now that you know all this about the S&P 500, is it even the right [00:14:00] index for you? What I would say is that based on the type of account that you have, your age, when you need the money, there are all different types of factors that play into whether the S&P 500 or any investment is correct.
You see this index over a long period of time has had wonderful returns, but that does not mean its returns have been consistent. And it doesn't mean that when you need your money, that would've been the right time to pull it out of this portfolio.
We gave the example of the FAANG companies, and you can look at what's been going on over the past year in the tech industry, and you can tell that if a bunch of those companies are heavily weighted in the S&P 500, there may have been more conservative companies that you could follow that would've been a better fit for what you're seeking to do.
What I'm describing are things like your risk tolerance, which is essentially your appetite for losing money in an investment before you decide to make a change. I'm also talking about your time horizon, which is the length of time before you think you will need all or a portion of the [00:15:00] money that you're investing, and all of those play a role in determining what you should and shouldn't follow.
So what I would say is I want you to be informed when it comes to tools like the S&P 500, but I also want you to understand that everybody's situation is different. And just because somebody at the dinner party told you all you need to do is put your money in the S&P 500 and let it ride, it does not mean that there's not more homework to be done when it comes to the investments you actually choose at the end of the day.
