Just about anyone who pays attention to the popular financial press knows that a broad market index ETF is the best way for a busy person to invest in U.S. stocks if they don’t have the time or inclination for researching individual stocks.
Over the past 40 years investors who have not attempted to beat the market but simply accepted market returns have done extremely well. The table below shows the cumulative return investors would have earned over various time frames had they invested in the original share class of the first U.S. stock index fund, the Vanguard S&P 500 Index Fund (VFINX), which launched in 1975.
Cumulative Return of Investments in the Vanguard 500 Index Fund
These results speak for themselves. They are also why Warren Buffett famously said, “A low-cost fund is the most sensible equity investment for the great majority of investors,” and advised his stockholders that, “My regular recommendation has been a low-cost S&P 500 index fund.” He put his own money where his mouth was when he made a million-dollar bet with hedge fund managers that over a period of 10 years he could beat their results just by investing in an S&P 500 index fund. Which he did.
While Buffett advised investors to invest in an S&P 500 index fund, there are advantages to investing in an ETF that tracks the S&P 500 rather than a mutual fund. ETFs are portable between brokers, while investors in broker-provided mutual funds may be charged a hefty fee to buy more shares if they move to a new brokerage. ETFs are less likely to distribute capital gains and trade like stocks so investors can set the price at which they want to buy shares rather than having to accept a fund’s share price that is set after the market closes.
So is it time for you to invest in an S&P 500 ETF?
Over Time the Total Return of the S&P 500 Sometimes Surpasses and Sometimes Lags that of the Broader Total Stock Market
The technology available in the 1970s made it very difficult to index more than the 500 U.S. stocks with the largest market capitalizations, so for a long time funds tracking the S&P 500 were the only broad market index funds available.
But investors today who want broad exposure to the U.S. stock market have an alternative. They can invest in Total Market ETFs which hold several thousand stocks, not just 500. This makes it seem like investors are getting greater diversification. But the actual performance differences between the S&P 500 ETFs and Total Stock Market ETFs like the Vanguard Total Stock Market ETF (VTI) are very small.
I see no reason to prefer one over the other. Over some time periods the S&P 500 ETF will outperform the Total Stock Market Fund, at others the Total Stock Market will outperform.
The table below shows you how Vanguard S&P 500 fund’s total return has compared with that of the Vanguard Total Stock Market Fund charging a similar expense ratio over various time frames going back 20 years. (I use the mutual fund share classes of these Vanguard securities here rather than the ETFs as they have been trading longer than the corresponding ETFs.)
Total Return of S&P 500 vs Total Stock Market Funds Compared
|Ticker||Name||YTD||1 Yr||5 Yr||10 Yr||Since 2000|
|VFIAX||Vanguard 500 Index Fund||-17.69%||-4.91%||78.77%||265.15%||295.45%|
|VTSAX||Vanguard Total Stock Market Index Fund||-18.88%||-7.98%||73.77%||253.36%||321.24%|
Don’t conclude from this that a Total Stock Market fund will always perform better over a very long time period. Just realize that one type of fund will do better than others in different kinds of markets.
What Makes the S&P 500 Unique
The S&P 500 is not quite a passively constructed broad market index. An algorithm chooses a list of all stocks eligible for inclusion in the index. But the actual stocks chosen are “a representative sample of stocks within each industry to the S&P 500” which are selected by a committee.
The index’s brochure states,
To be eligible for S&P 500 index inclusion, a company should be a U.S. company, have a market capitalization of at least USD 11.8 billion, be highly liquid, have a public float of at least 10% of its shares outstanding, and its most recent quarter’s earnings and the sum of its trailing four consecutive quarters’ earnings must be positive.
The most important of all these criteria is the requirement for some small history of profitability. This requirement has kept many highly speculative stocks out of the S&P 500. Though it means investors miss out on the very occasional mega cap stock like Tesla (TSLA) or Amazon (AMZN) that go for many years without reporting a cent in earnings, it also keeps out dozens of other highly speculative companies that never live up to investor hopes.
The profitability requirement partially explains why the S&P 500 funds and ETFs have performed slightly better over the recent period during which all broad market indexes have experienced sharp declines. Investors in a worried market are more likely to get out of unprofitable stocks and flee to tried and true stocks with a long history of profitability.
What Has Been the Average Return of an S&P 500 ETF?
Vanguard gives us the following data for the past 10 years of the Vanguard S&P 500 ETF’s (NYSEARCA:VOO) performance.
As you can see, total returns for a single year have varied from a 4.47% loss to a 31.47% gain. Because the S&P 500 has experienced a once in a generation boom during this period, VOO’s average annual total return, 17.11% for the whole decade starting in 2011 has been very high.
However, VOO only began trading in 2010, which was the beginning of the long boom market. If we look at the annualized total return of the mutual fund share class of Vanguard’s S&P 500 Index Fund, which has been trading a decade longer, the average return picture is far more muted. Since 11/13/2000 Vanguard reports that the average annual return of the S&P 500 index fund has only been 7.38%.
For an even longer perspective, we can look at the average return of the oldest S&P 500 ETF, the SPDR S&P 500 ETF Trust (NYSEARCA:SPY), which has been trading since January 22, 1993. That period includes the bull market of the 1990s, the long “lost decade” of the 2000s, and the boom of the 2010s. SPY’s product page tells us that its annual price return since 1993 averages 9.99%.
Obviously, there is no fixed total return investors can rely on receiving. The 7.38% return of the Vanguard fund over the bust and boom period is more likely to be what investors experience now as we are in the long tail of a boom. But there are reasons to believe that the S&P 500’s returns may be even more muted going forward.
Which Are The Best S&P 500 ETFs?
Let’s compare some metrics for the three most popular ETFs that track the S&P 500, which are the SPDR S&P 500 ETF Trust (SPY), the Vanguard S&P 500 ETF (VOO), and the iShares Core S&P 500 ETF (NYSEARCA:IVV).
VOO and IVV both have an expense ratio of .03%. SPY’s expense ratio is over three times higher at .0945%. SPY therefore, is not ideal for the buy and hold investor as that excess expense will eat into total return over time.
The Vanguard S&P 500 ETF with $229.55 Billion in assets is technically smaller than SPY with $350.31 Billion and IVV with $281.87 Billion. But Vanguard has a patent that allows it to treat VOO as a share class of its much larger Vanguard 500 Index Fund. The total holdings of all share classes of that fund including VOO are a whopping $760.1 Billion.
SPY has by far the highest average daily trading volume. Seeking Alpha tells us it averages 108.84 million shares a day. This dwarfs the 7.55 million shares traded of IVV and the 6.73 million of VOO. SPY also has the most active options market, making it a better choice for investors who use options to hedge of increase income. That said, the average trading volume of IVV and VOO are high enough that investors don’t have to worry about getting a poor price.
These are the current dividend yields of these ETFs.
IVV, VOO, and SPY Dividends
Differences in the payout date may explain some of the differences in the dividend yield, as some companies may have paid their dividends over the month that passed between SPY’s dividend payout date and those of IVV and VOO.
Somewhere between 95% and 99% of the dividends these ETFs pay out will be qualified dividends. Last year Vanguard reports that VOO’s dividends were 96.98% qualified. The others don’t make that information available online, but because they hold almost identical portfolios to VOO, the amount of their qualified dividends should be very similar.
Note that the dividend yields of all these ETFs are considerably lower than the S&P 500’s historical average yield. Below you can see a FastGraph showing how the S&P 500’s dividend yield has declined as its share price has surged. I have highlighted the yield at a time when it was more in line with its average before COVID-19 distorted market behavior.
The S&P 500’s Yield Has Declined as its Price Surged
The unusually low dividend also suggests that the S&P 500 is currently still overvalued. A better valuation might give investors a yield closer to 2%.
None of these ETFs has distributed capital gains, to date. Vanguard tells us that 38.20% of VOO’s NAV represents Unrealized Appreciation. SPY’s prospectus states at Year End 2021 it had 0% Unrealized Appreciation. I can’t find the corresponding number for IVV.
Theoretically VOO’s undistributed appreciation could result in the distribution of large taxable gains should Vanguard do something to drive institutional investors away from the VOO share class, as they did with their Target Date Funds. But as VOO is often held in taxable accounts, unlike the Target Date Funds, we have to hope Vanguard will not make such a destructive move.
Investor returns are an investors’ primary concern. All three ETFs track the S&P 500 pretty closely, with some underperforming the others at any given time.
Here is a table showing you how their historical total return has varied from each other over several time frames. The data here comes from Seeking Alpha’s Charting feature.
Comparative Total Return of SPY, VOO, and IVY
|Ticker||Name||YTD||1 Yr||5 Yr||10 Yr|
|SPY||SPDR S&P 500 ETF Trust||-16.31%||-3.32%||81.56%||269.71%|
|VOO||Vanguard S&P 500 ETF||-16.30%||-3.24%||82.17%||270.24%|
|IVV||iShares Core S&P 500 ETF||-16.23%||-3.19%||82.27%||272.23%|
It appears that IVV has a very slight edge in performance over both VOO and SPY, and that performance advantage seems to have held up consistently over the long and short term. The much greater advantage over the 10-year period might have to do with differences in the various ETFs’ expense ratios years ago, though there is no way to find out what they were as fund providers do not make that historical information public.
The Challenges Facing the S&P 500
There are several reasons why investors should be cautious about drawing conclusions about future returns from the S&P 500’s return history.
The 40-Year Decline in Interest Rates that Has Been a Tailwind For Stocks Has Ended
The S&P 500 funds and ETFs we have been looking at only traded during the very long period when interest rates were gradually, but inexorably declining from the extremes they had reached by the early 1980s when the Federal funds rate had reached 14.6% and investors could get a safe 17% in a brokerage money market fund. It was only when rates started to decline around 1982 that retail investors, who had shunned stocks during the era of high inflation, began to invest again.
Now, however, inflation has suddenly become a major threat to the economy and it is very likely that rates will rise again at least for several more years. This can have a very quelling effect on companies’ ability to increase profits.
S&P Stocks are Still Very Expensive When Measured Against Their Earning Potential
When investors rediscovered stock investing, starting back around January of 1982, the Price/Earnings ratio of the S&P 500 was only 7.73. That is a P/E ratio that is roughly a third of where it is now.
The price of the S&P 500 has dropped almost 20% since the end of 2021 when its P/E ratio hovered around 23. There are many conflicting numbers available for what its current P/E ratio might be, but the consensus seems to put the current P/E ratio now around 19.
State Street Global Advisors tells us that the P/E ratio of the S&P 500 as of May 20 was 18.91. It does not give a current P/E ratio for SPY. The iShares Core S&P 500 ETF, another large ETF that tracks the S&P 500 tells us that the P/E ratio of IVV as of May 20, was 19.17.
The data that Vanguard gives us for VOO, is, as usual almost a month out of date as they only report metrics as of April 30, 2022. At that time the P/E ratio of VOO was 20.3. Since the price of VOO has dropped 6.05% since April 30, comparing Vanguard’s April 30 number with the more recent ones from the other ETF providers suggests that a drop of around 6% in the S&P 500’s price may cause its P/E ratio to drop slightly less than 1%, assuming that earnings stay constant.
FastGraphs tells us that the average P/E of the S&P 500 over the decade between January 2010 to January 2020 was 16.97. (I selected that period as it is ends before the disruptions caused by COVID-19 caused a sharp one-time-only distortion in market dynamics.) That suggests to me that the S&P 500’s P/E is still high and that a drop in share price that would bring that 19 P/E ratio down to 17 or lower is quite likely to happen.
Three Revolutions Gave the S&P 500 the Stocks that Make up Much of Its Value. Their Future Earnings May Determine its Returns
Let’s take a quick glance at the heat map showing what kinds of stocks dominate the S&P 500 by weight.
Sector Impact by Weight on the S&P 500
As you can see, Information Technology makes up more than a quarter of the total value of the S&P 500.
Not that you won’t get a significantly different sector weighting with a supposedly more diversified Total Stock Market ETF. The Information Technology sector makes up 26.38% of the total value of the Vanguard Total Stock Market ETF and the Health Care sector makes up 13.27% of VTI, despite it holding 4,112 stocks rather than the 504 currently in the S&P 500.
Most of the stocks assigned to the Communications Services sector are internet-related stocks like Alphabet, formerly known as Google (GOOG) (GOOGL) and Meta Platforms, formerly known as Facebook (FB). If you add them to the official Technology sector stocks you find that almost 35% of the entire value of the S&P 500 lies in U.S. stocks that participated in the Personal Computer, Smart Phone, and Internet revolutions.
The question for investors in an S&P 500 ETF now is whether these companies, some of which have multi-trillion dollar market caps, can continue to grow their earnings at a rate that justifies the very high Price/Earnings ratios they have been given by investors used to seeing them achieve double digit annual earnings growth.
As I discussed in several recent articles including 4 Dangerously Valued Mega Cap Stocks May Determine The Future Of Your Market Cap Weighted ETFs earnings growth has slowed down for several of the most visible of these stocks. Because of their high valuations, any but the most positive news can tank their stock prices within minutes. More such disappointments, spreading through the many still highly valued technology-related stocks in the index could continue to damage the S&P 500’s price.
Below you see an example of what happens to a mega cap stock when its earnings disappoint. Note that Meta Platforms, unlike many Tech-related stocks, actually appeared decently valued before its price collapse.
FB’s Steep One Day Price Decline After Disappointing Earnings
The S&P 500’s Value Is Far More Concentrated in A Few Highly Valued Stocks than Ever Before
The graphics below, provided by J.P. Morgan Asset Management shows you just how concentrated the total value of the S&P 500 has become over just the last decade and how inflated the Price/Earning ratios of those top stocks are currently.
This data is as of March 31, 2022. The prices and valuations of some of those top 10 stocks have decreased significantly, but as you can see, even with some downward adjustment they are still very high by historical standards. The last time the S&P 500 index was dominated by a few highly valued stocks was back in the days of the Dot.com boom. After it burst, it took well over a decade for most of those stocks to regain their former highs.
Consumer Stocks Are Also Heavily Weighted in the S&P 500, Highly Valued, and Very Vulnerable to Inflation
A total of 17.15% of the S&P 500’s total value by weight, and hence that of the ETFs that track it, is made up of stocks in the Consumer Staples and Consumer Discretionary sectors. Stocks in these sectors are very vulnerable to inflation because it raises the prices of the labor, transportation, and materials that consumer-facing companies need to buy in order to provide their goods or services.
These consumer-facing stocks are also still very highly valued. The index tracked by the Consumer Discretionary Select Sector SPDR® Fund (XLY), which holds the Consumer Discretionary stocks in the S&P 500, had a P/E ratio of 22.10 as of May 20, 2022, and that is after it had suffered a 20.15% price decline.
Raising consumer prices too high can drive customers to cheaper competitors or stop them from buying discretionary products at all. So when inflation gets going, these companies typically take a hit to their margins, earnings drop, and stockholders take profits while they can. Walmart’s (WMT) 1st Quarter earnings report suggested that this is already beginning to happen.
Walmart Plunges After Disappointing 1st Quarter 2022 Earnings
Since the valuations of many of the largest cap Technology and Consumer-facing stocks are still high, earnings that barely meet expectations or disappoint this year may bring down the price of the S&P 500 ETFs further.
Investors Worry We Will See a Repeat of 2000’s Very Slow but Devastating Crash
Since the beginning of this year, the S&P 500’s price has been on a downward course that reminds a lot of us oldsters of how stocks behaved in 2000–another period when the S&P 500 was dominated by a small number of highly valued stocks whose prices collapsed, in some cases far below what a reasonable valuation would predict.
This is a chart of how the price of SPY behaved over the course of the very slowly developing 2000-2002 crash. It maps SPY’s price from January 4, 2000 to October 8, 2002.
The Very Slow Crash of Jan 2000 – Oct 2002
Unlike the fast crashes investors experienced in 2008, 2018, and 2020, the crash that resolved the overvaluation of the Dot.com era took a long time to unfold. As you can see there were nine different periods where SPY’s price looked like it was recovering, only to fall further. It then took until 2007 for SPY to rise to where it had been in early 2000, after which it plunged more than 50% again during 2008’s Financial Crisis.
Some investors argue that the companies dominating the S&P 500 today are far healthier than those of the 1990s. But investors buying S&P 500 ETFs now should be aware that investor sentiment about the direction the S&P 500 is heading is definitely less consistently positive than it has been for the past several years.
Is Now A Good Time To Invest In S&P 500 ETFs?
For Those Making Small Monthly Investments
If you are making small monthly investments, where you get the benefit of “time diversification,” and if you intend to hold your S&P 500 investment for a decade or two or three to provide you with a retirement nest egg, yes.
Even if you buy at what turns out to be a high price now the chances are very good that in a few decades your investment will be worth far more than it is now, if only because eventually stocks do catch up with inflation. Investors who bought in 1999 and 2008, just before devastating, long-lasting market crashes, have still seen very satisfying returns.
Here is how your total return would look if you had bought the iShares Core S&P 500 ETF at the all time high before the Great Financial Crisis devastated the stock market. Its long-term 259.54% return is nothing to sneer at, even though before achieving that return investors had to have the fortitude to hold their shares through a period when they saw their original investment drop by 44.62%.
IVV Total Return Since Its Pre-Financial Crisis High
For Those Investing a Once-in-a-Lifetime Windfall
If you are looking to invest a large amount at once, like the proceeds from the sale of a business or an inheritance, I would advise caution. If today’s inflation turns out to be persistent, like that of the 1970s, it could have a very negative effect on business earnings.
Bottom Line: Don’t Rely on Backtesting When Investing in S&P 500 ETFs
These ETFs have all been superb investments during the 40 years when inflation has gradually come down making stocks increasingly attractive to investors and making it easy for companies to finance innovation. The S&P 500 ETFs have provided double digit average annual returns through the period when most workers now investing have been in the market. But it is quite possible that the S&P 500 and the ETFs that track them will see much more muted returns for the next decade and possibly longer.
We don’t have any useful information for how persistent inflation could affect these S&P 500 ETFs. There were no S&P 500 funds available in the 1960s when the high inflation of the 1970s began. Even data from the Vanguard 500 Index Fund going back to 1975 isn’t very useful because investing was so different back then, being mostly conducted by professionals in insurance companies and pension funds. Few investors had the resources to pay the high brokerage fees it cost to buy stocks.
We can know that inflation makes it more challenging for both corporations and consumers to manage their debt. We also know inflation limits the consumer’s ability to pay for the technological marvels and consumer goods produced by the companies that contribute such a large part of the S&P 500’s value.
Even without inflationary pressures, the future performance of SPY, VOO, and IVV is very much dependent on the extent to which the mega cap companies that dominate it by weight can continue to innovate and grow their earnings. If that growth slows, as it appears to be doing, the S&P 500 ETFs may be in for a long slow period.
Investors who put money into SPY, VOO, or IVV now should be fastening their seat belts. Don’t invest money you may need in the next 10 years. Don’t look at your account balance when the market has a hissy fit. The secret to successful investing with any of these ETFs is to buy and hold them for decades.
Read More: Is Now A Good Time To Buy S&P 500 ETFs?