How S&P 500 Funds Work - TheStreet

Should I Invest in the S&P 500? How Do I Get Started?

Here's a primer on how S&P 500 funds work, and whether they might work for you
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By Tiffany Lam-Balfour

For those would-be investors wanting to jump into the stock market but wondering which stock to buy, legendary investor Warren Buffett has a suggestion: Try buying 500 stocks instead.

“In my view, for most people, the best thing to do is own the S&P 500 index fund,” Buffett said at Berkshire Hathaway’s annual meeting in May. But what is the S&P 500, and how do you invest in one of its funds?

Here’s an intro to how S&P 500 funds work, and whether one might be a good fit for your portfolio.

What Is the S&P 500?

The S&P 500, or S&P, is a stock market index comprising shares of 500 large, industry-leading U.S. companies. It is widely followed and often considered a proxy for the overall health of the U.S. stock market.

Standard & Poor’s, an American investment information service, created the index in 1957. Every quarter, its investment committee meets to review which stocks belong in the index based on each company’s market size, liquidity and group representation. Today, 505 stocks constitute the index, since some of the 500 companies have more than one class of shares.

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Contrary to popular belief, the stocks forming the index are not the 500 biggest U.S. companies, but they are arguably the 500 most important companies. Over $11.2 trillion is invested through the index, with these 505 stocks representing about 80% of the total U.S. stock market’s value.

The S&P 500 is a cap-weighted index, meaning each stock within the index is weighted according to its market capitalization, or total market value (number of outstanding shares multiplied by current market price). The larger the company, the greater its influence on the index.

As of Aug. 31, 2020, these are the top 10 companies by index weight in the S&P 500:

How Do You Invest in the S&P 500?

An index is a measure of its underlying stocks’ performance, so you cannot directly invest in the index itself. Buying every company’s shares would be an arduous task (think 505 separate transactions), but thankfully there are index funds and exchange-traded funds, or ETFs, that replicate the index, effectively doing that work for you.

While all S&P 500 SPX funds track the holdings of this index, an investor must consider whether using an index fund (a passively managed mutual fund) or an ETF makes the most sense for them. The good news when weighing index funds versus ETFs is that there are solid S&P 500 options in each category, and all of these products leverage the diversity of the index itself.

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Because the S&P 500 is weighted by each company’s market capitalization, the larger companies in the index can sometimes have an outsize impact on the performance of the larger index. In other words, a big dip in price for Apple shares can create a dip in the index as a whole. Because of this, some investors prefer to purchase the S&P 500 in an equal-weighted format, so that each company has the same impact on the index. This is meant to create an index that is more representative of the overall U.S. market.

After deciding your preference for an index fund or ETF, cap-weighted or equal-weighted, you can begin narrowing down which S&P 500 fund to purchase. To minimize your costs, look into each fund’s expense ratio — the percentage of your assets you’ll pay in fees each year — to see how they compare.

Fees are important here since all of these funds track the same index, which means their returns should be roughly the same. The lower the fee, the more of that return you keep.

Should You Invest in the S&P 500?

There are a number of things to think about before you choose any investment. But an S&P fund can generally be a good choice if you want to add broad exposure to the U.S. stock market to your portfolio.

“The S&P 500 is a key part of a diversified investing strategy because it’s a good bet that the U.S. economy will continue to succeed and grow in the long term,” says Tony Molina, senior product manager at Wealthfront. The U.S. has the largest economy and stock market in the world, and is one of the most resilient and active, especially when it comes to innovation. That’s why it’s a no-brainer to include the S&P 500 as part of your portfolio.”

Larger companies are generally more stable to invest in because they are well-established and widely followed. Thus, these stocks usually have less risk and lower volatility. The S&P 500 combines large companies across various industries, so investors access a broad, diversified mix of companies when investing in it.

Choosing an index fund or ETF can also help investors avoid — or at least minimize — the behavioral pitfalls from stock-picking, which is a losing strategy, says Dejan Ilijevski, president of Sabela Capital Markets.

Ilijevski cites the May 2018 study by professor Hendrik Bessembinder at Arizona State University, which examined investments in publicly traded U.S. stocks between 1926 and 2016 and found that just over 4% of the companies accounted for the total wealth created.

“Picking those few individual winners is impossible,” Ilijevski says. “Your best bet is to own as much of the market with a fund that tracks the index.”

Using index funds and ETFs can help investors generate strong returns while also minimizing their costs, says Kevin Koehler, chartered financial analyst and director of the investment strategy group at Miracle Mile Advisors in Los Angeles.

“Investing in the S&P 500 the past 25 years would have given an investor over a 10% annualized return, proving that an investor does not need to be paying high expenses to get good market returns,” Koehler says.

Are There Drawbacks to Investing in the S&P 500?

There are caveats to consider. The S&P 500 consists of only large-cap U.S. stocks. Portfolio diversification encompasses buying mid- and small-cap companies along with large-caps; allocating funds to international companies along with domestic ones; and including bonds, cash and potentially other asset classes with stocks.

Koehler also notes drawbacks in the S&P 500 related to its market-cap weighting.

“As passive investing increases, investors are continually investing in S&P 500 funds, which has contributed to a ‘rich get richer’ problem, where the largest stocks are getting larger due to S&P 500 investing, rather than individual stock investing,” Koehler says. “This can lead to higher volatility, as active managers sell an individual stock on top of index funds selling a portion. The market could continuously be overvalued compared to its underlying value.”

But relative to the downsides of many investment types, the flaws of S&P 500 funds seem relatively minor, especially when used as a part of your overall portfolio and held for the longer term. This helps explain why icons like Buffett have so publicly endorsed them.

“I happen to believe that Berkshire is about as solid as any single investment can be, in terms of earning reasonable returns over time,” said Buffett at the May meeting, speaking about the investing company he’s turned into an empire. “But, I would not want to bet my life on whether we beat the S&P 500 over the next 10 years.”

This article is reprinted by permission from NerdWallet.

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Tiffany Lam-Balfour is a writer at NerdWallet. Email: tlambalfour@nerdwallet.com.