In his book, A Random Walk Down Wall Street, the Princeton Professor Burton Malkiel writes that “a blindfolded monkey throwing darts at a newspaper’s financial pages could select a portfolio that would do just as well as one carefully selected by experts.” This idea is at the core of the debate between active vs. passive money management.

If you find yourself on the conservative end of the active vs. passive spectrum, then investing in exchange-traded funds (ETFs) may be one way to go. You may not beat the market, but you will certainly come close to matching it.

What are ETFs?

Exchange-traded funds have been around for over 30 years now, but their relative popularity has increased exponentially in the past decade. These are funds that track indexes, like the S&P 500, Dow Jones Industrial, Russell 1000/2000/3000, NASDAQ-100, etc., and in doing so, replicate their performance. The best part about ETFs is that they provide the benefit of diversification of a market index together with the flexibility of owning and trading a single stock. ETFs, just like stocks, can be purchased on margin, held long-term, or sold short, and unlike index funds, they can be traded throughout the day. (For more, see: Exchange Traded Fund (ETF).)

In this article, we’ll focus on ETFs that track two of the more popular indexes: the S&P 500 and the Russell 2000.

The S&P 500 ETFs

The three most commonly traded ETFs that track the performance of the S&P 500 index are State Street’s SPDR S&P 500 ETF Trust (SPY), BlackRock’s iShares Core S&P 500 ETF (IVV), and Vanguard’s S&P 500 ETF (VOO). The common theme between all three is, of course, the index they track—the S&P 500. Many investors consider this index to be the pulse of the US equity market. It is calculated using the market capitalizations of the 500 largest US companies with stocks listed on the New York Stock Exchange or the NASDAQ Stock Market. Index constituents are selected by a committee, which takes into account criteria such as market capitalization, liquidity, financial viability, length of trading, etc.

The oldest and the most widely held of the three ETFs is SPY, with the value of net assets at $195.79 billion as of October 2016. Its fees of 0.09%, albeit negligible in a broader asset management context, are the highest among the three. This is reflective of its superior liquidity, with average daily trading volume of 30 to 60 times that of IVV and VOO.

Name Symbol Net
Assets
Avg Volume (3m) Expense
Ratio
SPDR S&P 500 ETF Trust SPY 195.79B 84.3M 0.09%
Shares Core S&P 500 ETF IVV 80.02B 3.1M 0.04%
Vanguard’s S&P 500 ETF VOO 51.65B 1.9M 0.05%

Data Source: State Street Global Advisors, iShares.com, Vanguard, Yahoo Finance as of September and October 2016.

All three ETFs slightly underperformed the S&P500 index over the last 10 years, with SPY returning the lowest of the three. This is to be expected, since it has the highest expense ratio among the three ETFs and we are comparing it to the virtually frictionless S&P 500 Index.

Performance SPY IVV VOO* S&P 500
1 year 15.30 15.37 15.39 15.43
3 years 11.04 11.10 11.12 11.16
5 years 16.21 16.30 16.33 16.37
10 years 7.14 7.19 * 7.24

* VOO fund inception date is September 9, 2010.

All the performance numbers represent NAV returns

Data Source: State Street Global Advisors, iShares.com, Vanguard, Yahoo Finance as of September and October 2016.

SPY is also structurally different from IVV and VOO in that it is set up as a unit investment trust with restrictions on lending the underlying shares to other firms. Additionally, any dividends from SPY constituents for the period are collected and held in cash until distribution, whereas IVV and VOO allow for reinvestment of dividends.

The Russell 2000 ETFs

As the name suggests, Russell 2000 ETFs closely track the Russell 2000 Index, which combines 2000 of the small cap companies in the Russell universe of 3000 stocks. Both the S&P 500 and Russell 2000 indexes are market capitalization weighted. Unlike the S&P 500 index, however, the securities in the Russell 2000 index are not selected by a committee, but rather through a formula based on their market cap and current index membership. (For more, see: How the S&P 500 and Russell 2000 Indexes Differ.)

The most notable ETFs tracking the Russell 2000 index, in the order of their significance, are BlackRock’s iShares Russell 2000 ETF (IWM), Vanguard’s Russell 2000 ETF (VTWO), and State Street’s SPDR Russell 2000 ETF (TWOK).

Name Symbol Net 
Assets
Avg Volume (3m) Expense
Ratio
iShares Russell 2000 ETF IWM 27.1B 23.14M 0.20%
Vanguard’s Russell 2000 ETF VTWO 695M 56,541 0.15%
SPDR Russell 2000 ETF TWOK 133M 19,653 0.10%

Data Source: State Street Global Advisors, iShares.com, Vanguard, Yahoo Finance as of September 2016.

Here again, the higher liquidity of the iShares Russell 2000 ETF (IWM) seems to drive its higher expense ratio. Compared to the S&P 500 ETFs, however, all funds tracking the Russell 2000 index command higher fees despite a much lower overall liquidity. IWM is the heaviest traded Russell 2000 ETF, yet it trades at just one quarter of the SPDR S&P 500 ETF (SPY) volume. The higher fees of Russell 2000 ETFs are likely due to the increased management effort of periodically balancing larger number of securities.

Russell 2000 ETFs may look more attractive than S&P 500 ETFs at the start of a bull market. The Russell 2000 constituents on average are bound to outperform their big brothers in S&P 500 Index if the uptrend continues. The challenge is the volatility of their returns, so as an investor you may be in for a rough ride.

The Bottom Line

The advantages of ETFs are self-evident. In reality, very few active managers can beat the market, making ETFs an attractive investment for those who are content with matching the return on a wider market at a fraction of an active management cost. Investors have many ETFs to choose from based on the size, geographical location, or sector affiliation of companies in the index. Two of the more popular choices are S&P 500 ETFs and Russell 2000 ETFs. Key distinctions between them are driven by the size of the companies in the index they track (i.e., large-cap for the S&P 500  and small-cap for the Russell 2000), the volatility of the underlying index, the method of constituent selection, and the fees they charge. 

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