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
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
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
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
2010 Index Publications LLC
. All Rights Reserved.