The Case Against The Largest ETFs

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While most of us writing about ETFs have talked a lot about niche products and how to play them, the flows data paint a far different picture:The money is in the big three.

The SPDR S&P 500 (NYSEArca:SPY), PowerShares QQQ (NYSEArca:QQQQ) and SPDR Dow Jones Industrial Average Trust (NYSEArca:DIA) ETFs have long been the bellwethers for all other funds in the marketplace.

They collectively make up $122 billion in assets under management and dominate the charts for creations and redemptions almost every day. They're the titans of exchange-traded funds. There's a good chance that you have a little bit of these funds in your own portfolio.

But you shouldn't.

Even though these three funds are juggernauts, they're far from perfect. What's worse, they may not be providing what your portfolio needs.

DIA is designed to provide exposure to the top 30 securities on the Dow Jones Industrial Index-the oldest and possibly best-known indicator of market movement. To its credit, DIA generally does this well. But its index is itself flawed.

The Dow Jones Industrial Average Index is built as a modified price-weighted index. In simplest terms, it values securities that trade at a higher price more than those that trade lower, for no reason other than the share price in dollars.

Even worse, the index is built around 30 of the largest stocks in the marketplace. Thirty! Imagine applying this same line of thinking to your dinner options. What if you could only eat at the 30 largest restaurants? Your diet would quickly consist of Whoppers and McNuggets.

The Qs isn't much better. Driven by the Nasdaq-100 Index, QQQQ is often used by investors who want exposure to the tech sector. It's an assortment of domestic and foreign securities that explicitly leaves financial stocks out, so tech companies play a large role. But the unusual weighting scheme leaves me puzzling over why it's so popular.

Billed as a "modified market-cap weighted index," QQQQ's weighting is as much a roulette wheel as it is a sound methodology. As I've explained before, an effort to cap the influence that Microsoft had on the index when it was created in the late 1990s dramatically skewed the weightings in the portfolio. Today, Apple makes up more than 20 percent of the index-five times as large a position as Microsoft, despite the fact that the two companies are roughly the same size.

Apple's cool and all, but for an index to have a 20 percent position in any single company is just crazy.

That leaves us with the granddaddy of them all, the SPDR S&P 500 ETF (NYSEArca:SPY). With $93 billion in assets, SPY is the 900-pound gorilla of passive investment. And it deserves to be-after all, it was first. But it's certainly not the best.

There are reasons to use SPY in your portfolio. Traders love SPY, as it is one of the most liquid securities in the world. But SPY is structured as a grantor trust, not as a '40 Act fund like most modern ETFs.

The chief drawback of its structure is that it can't reinvest its dividends, meaning it has a small, persistent cash drag that will slightly lower its beta to the index. You can stay fully invested with an alternative like the iShares S&P 500 ETF (NYSEArca:IVV). Not quite as good for trading as SPY, but great from a long-term perspective.

Or better yet, turn away from the S&P 500 altogether and look at a less popular and more academically sound index like the MSCI 300. There's increasing concern that investors are front-running rebalancing trades in the most popular indexes, to the detriment of returns. By moving into less popular indexes, you may be able to eke out a slightly improved return.

So why do so many move into these big indexes? We all claim to be fans of rationalism in passive investing, but the $122 billion dumped into these three imperfect funds says otherwise.

Investors can be smarter. If you're looking for a fund to replace the big three in your portfolio, you could do a lot worse than Vanguard's Total Stock Market ETF (NYSEArca:VTI). Its 0.07 percent expense ratio is cheaper than SPY and its underlying index makes far more sense.

Or better yet, you could use one of the other 1,100+ ETFs that provide radically different exposure, diversifying your portfolio and moving away from the mob mentality.

ETFs are championed as diversifiers in the market, providing options to investors that they've long been kept from. Isn't it time we start using them that way?

Don't forget to check IndexUniverse.com's ETF Data section.

Copyright ® 2010 Index Publications LLC . All Rights Reserved.



The views and opinions expressed herein are the views and opinions of the author and do not necessarily reflect those of The NASDAQ OMX Group, Inc.



This article appears in: Investing , ETFs

Referenced Stocks: DIA , IVV , QQQ , SPY , VTI

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