Should You Buy The S&P500 Or Include More Large Caps?

By: Pete
Date posted: 03.30.2012 (2:25 am) | Write a Comment  (0 Comments)

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For good reason, many investors end up wanting to get exposure to the US equity markets. It is after all the largest market around the world by far and no matter where you are (especially for Americans), holding a good portion of those assets in US stocks seems like a very reasonable idea.

The Part I Don’t Understand

A majority of those investors end up buying ETF’s which is obviously a great way to get exposure but they very often end up buying ETF’s that track the S&P500. Why that index? There are several others right? The Down Jones Industrial Average, the Nasdaq-100, the S&P500, the Russell indexes, etc. So why do most investors end up going for the S&P500?

Is it because there are more alternatives? You can easily see 5 or 6 ETF’s that track that index with minimal fees or tracking error. However, I think that comes down to the Chicken vs. Egg debate. I would argue that those fudns are there because there was demand. Besides, there are also very good alternatives for those wanting to buy into the other indexes such as QQQ for the Nasdaq, DIA for the Dow Jones, etc.

Seems Illogical To Only Go For The S&P500

If you compare an index ETF like VTI, which invests in 3000 of the largest US stocks, rather than the 500 stocks in the S&P500, here is what you get:

-Smaller firms that will be the large caps of tomorrow
-More dynamic firms
-A better representation of the US economy (small caps have been able to generate a large part of the growth in the past century)

In the end, I would expect an index that has small cap firms to outperform in a case like this. I did compare the returns of two big US ETF’s,

SPY (S&P500)
IWM (Russell 2000)

And not a big surprise to see that IWM has outperformed SPY in the past 5 years, by over 2%! That is very significant!

So Why Would Investors Not Use These Alternative Funds More?

I think a big part of the problem is that the S&P500 has been able to become very popular and its return is usually the first one to be discussed in the media. That has certainly contributed to making investors aware of the index as the one to track, the one to beat. Sometimes, that is enough to do the trick. How often did you hear about broader indexes such as the Russell 2000 or Russell 3000 indexes in the tv, media etc? I would imagine it’s very rare. Even the very deficient Dow Jones Industrial Average seems to be able to generate more interest despite all of its flaws.

What would you be buying the next time you are looking for exposure to US equity markets? If it’s not a braod large and small cap index, why?

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