It's difficult to make a case against an S&P 500 index fund -- particularly the SPDR S&P 500 ETF (NYSEMKT:SPY). That's because these index funds have a lot going for them, such as their simplicity, convenience, low cost, and outperformance versus managed mutual funds.
Still, they're not perfect. Let's review some of their drawbacks.
Not a perfect market proxy
A common selling point of S&P 500 index funds is that they allow you to easily and inexpensively invest in most of the U.S. stock market. Indeed, when it comes to market capitalization, the index's 500 components make up about 80% of the overall U.S. stock market. In the words of S&P Dow Jones Indices, "The S&P 500 is widely regarded as the best single gauge of large cap U.S. equities. There is over USD 5.14 trillion benchmarked to the index, with index assets comprising approximately USD 1.6 trillion of this total."
That's impressive, sure, and 80% of the market is indeed most of it. But the missing 20% is not insignificant: It includes several thousand companies, many of them small caps. Small-cap companies are worth including in a portfolio for diversification and their great growth potential. If you want an investment that truly represents the entire U.S. stock market, including both big and small companies, this is not the index for you.
You do have some options, though. You might simply keep the S&P 500 index fund and add a small-cap index fund to it, such as the inexpensive Vanguard Small-Cap ETF (NYSEMKT:VB), which has outperformed the S&P 500 over the past five and 10 years. Alternatively, you could forget the S&P 500 index fund and opt for a fund that includes the entire market, such as the Vanguard Total Stock Market ETF (NYSEMKT:VTI), which is also inexpensive and has also outperformed the S&P 500 over the past five and 10 years.
The SPDR S&P 500 ETF is structured in ways that some find suboptimal. For starters, its 500 holdings are weighted by market capitalization, so the biggest companies have more influence. Thus smaller and potentially faster-growing companies have relatively little influence. Its top holdings, unsurprisingly, include Apple, Microsoft, and ExxonMobil. Consider General Electric, with a recent market cap near $263 billion, and First Solar, with a market cap near $5 billion. Both are components of the S&P 500, but General Electric's stock has more than 50 times the influence of the smallish solar-energy company.
However, you can get around this, too, because there are a number of S&P 500-based ETFs that weight their components differently than the index itself. The Guggenheim S&P 500 Equal Weight ETF (NYSEMKT:RSP), for example, gives each of the 500 components equal weighting, and it has outperformed the S&P 500 over the past five and 10 years. Keep in mind, though, that its expense ratio, or annual fee, is 0.40% -- more than four times the SPDR S&P 500 ETF's expense ratio of 0.09%. The RevenueShares Large-Cap ETF (NYSEMKT:RWL), which weights its components by their annual revenue, has also outperformed the S&P 500 over the past five years, but it hasn't yet been around for 10. Its expense ratio is 0.49%. In both of these cases, the outperformance more than made up for the fee difference.
The Google effect
Another concern is what has been called "the Google effect." That's because of what happened when Google was added to the S&P 500 back in 2006. The folks at the S&P 500 announced that Google was being added to the index after the market closed on March 23, but when the stock began trading the next morning, it had popped up more than 7% overnight due to a surge in demand, forcing all the index funds that now had to buy the stock to pay more for it. This has happened many times when a stock has been added to the index. One way to avoid this effect is to stick with a broader-market index fund, such as the Vanguard total market fund mentioned above.
S&P 500 index funds like the SPDR S&P 500 ETF are compelling investments, outperforming many alternatives and costing investors little. But if you're willing to do a bit of homework, you can find better options.
Longtime Fool specialist Selena Maranjian, whom you can follow on Twitter, owns shares of Apple, General Electric, Google (C shares), and Microsoft. The Motley Fool recommends Aflac, Apple, and Google (A and C shares) and owns shares of Apple, General Electric, Google (A and C shares), and Microsoft. Try any of our Foolish newsletter services free for 30 days. We Fools don't all hold the same opinions, but we all believe that considering a diverse range of insights makes us better investors. The Motley Fool has a disclosure policy.