A:

The S&P 500 and Dow Jones Industrial Index (DJIA) are two of the most well-known indexes tracking the movement of the U.S. market. When either of these indexes is moving up, the stock market as a whole is considered to be doing well. The return for either index is often used as a benchmark in comparing the performance of a mutual fund. Many investors over time have been unimpressed with the return of their mutual funds, compared to the return of the index or the market as a whole. This investor attitude has resulted in an increase in the number of investment products that solely track the changes in the index, providing investors with similar returns. One of the most popular of these investment vehicles are exchange-traded funds.

While the benefits of these type of funds are familiar to investors, the accuracy to which they track the index is not. The most common ETFs tracking the contents of the S&P 500 and the DJIA are Spiders, or SPDR for Standard and Poor's Depository Receipt, and Diamonds. Both of these trade on the American Stock Exchange under the symbols SPY and DIA and can be bought and sold at anytime during market hours. Both of these ETFs work on a roughly 10:1 basis meaning that if the DJIA is valued at 10,000 points corresponding to a dollar value, the DIA will be around $100. It is a rough equivalent because the ETFs are constantly traded in the market, their value will not always mirror the index. For example, it is not uncommon for the S&P 500 to be up for the day while the SPY is down. The reason for this is that the index tracks the return of the underlying stocks but is not traded. The ETF, on the other hand, is a depository receipt of the underlying stocks that the index tracks and it is traded daily. It is the trading of the ETF that causes the variation in returns with the S&P 500's. For example, if all of the stocks in the index are up during the day, the index will also be up however if investors in the ETF sell because they do not feel good about the prospects of the market looking forward, the ETF will be down. However this is not be a major concern as the divergence between the index and its ETF are relatively minor and tend to revert back to each other. The reason for this is that the underlying value of the ETF is the companies in the index itself so there is little reason for the two to vary widely.

spy.gif

The above chart illustrates the difference between the return of the SPY and the S&P 500 over a one-month period. As can be seen, the ETF (black line) actually outperformed the index (red line). However, this difference was around 0.2% as both the ETF and the index returned around 3.5% in the period. The variation between the index and ETF are considered minor and impact the substantial benefits of these investment products in no material way.

(For further reading, see Introduction to Exchange-Traded Funds and Advantages Of Exchange-Traded Funds.)

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