Invest in the S&P 500 Index with SPY - dummies

By David Stevenson

To minimise the risks involved in managing your investment portfolio, you can invest in the UK in an index-tracking fund (also called exchange-traded products or ETPs), the most common form being an exchange-traded fund (ETF).To help you understand the beauty and simplicity of an ETF, look at a very successful example: investing in the S&P 500 index, the world’s leading blue chip equity index.

How the S&P 500 works

You decide that this benchmark index gives you the right exposure to the world’s leading profit-making companies. You consider investing in the big stocks within the index (outfits such as Apple and Exxon), but decide that you want more diversification and no risk of picking the wrong stocks.

Therefore you have to choose a fund, because dozens of S&P 500 trackers are available, issued by a multitude of large banks and fund-management groups. You decide (for right or wrong) to invest in the biggest of all. This ETF has the ticker SPY, is listed on the New York Stock Exchange and is managed by huge fund-management company State Street.

This S&P 500 tracking fund has a number of key characteristics, including (at the time of writing):

  • Market capitalisation of US$103 billion.

  • A charged total expense ratio (TER) of 0.10 per cent.

  • A dividend (paid quarterly) derived from the companies that it invests in; the yield was 1.90 per cent in late August 2012.

  • Shares in the fund are listed on the US stock market.

  • Market price of the last reported trade on the exchange was US$141.79 per share.

SPY invests in the constituents of the S&P 500. The following table shows the top ten holdings within the fund, with familiar names such as Apple, Exxon and Microsoft topping the list. Needless to say, another 490 stocks reside in addition to these top ten holdings. The table details the weight of each company the fund holds; for example, shares in Apple comprise 4.80 per cent of the total value of the SPY fund.

Top Fund Holdings in SPY Index Tracker as of 21 August 2012
Name Weight (%)
Apple Inc 4.80
Exxon Mobil Corp 3.20
Microsoft Corp 1.80
International Business Mach 1.79
Chevron Corp New 1.73
General Electric Co 1.73
AT&T Inc 1.68
Johnson & Johnson 1.46
Procter & Gamble Co 1.43
Wells Fargo & Co 1.43

For comparison, the table looks at the S&P 500 index being tracked by the SPY fund. Almost instantly you can spot that the companies in the index mirror the companies in the fund.

This fund tracks the index and the aim of the exercise is to make that replication as close to perfect as possible. In fact, the fund website shows that over the last year the correlation between the SPY tracker and the S&P 500 is exactly 1, which means that they move as one, going up and down together in response to market events.

Top Companies within the S&P 500 Index as of 21 August 2012
Name Weight (%)
Apple Inc 4.85
Exxon Mobil Corp 3.21
International Business Mach 1.80
Microsoft Corp 1.79
Chevron Corp New 1.73
General Electric Co 1.73
AT&T Inc 1.69
Johnson & Johnson 1.45
Procter & Gamble Co 1.43
Wells Fargo & Co New 1.41

S&P (the index provider) decides on the exact weighting in the index by using market capitalisation – a simple notion that relates to the efficient market theory. Market-capitalisation-based indices are by far the most common form of index construction. A few other ways of building an index also exist.

Understanding the SPY tracking structure

The managers of the SPY ETF use a lot of computing power to make sure that they constantly track the S&P index via their fund, plus an active trading desk (where they can execute buying and selling transactions). For example, if the price of Apple declines by 10 per cent in value on one day, bringing its weighting within the index down from 4.85 per cent (as in the preceding table) to 4.37 per cent, State Street’s fund managers sell their holdings of Apple shares to make up the difference.

The key to this particular index fund is that the managers are physically replicating the index. So, if a particular share is in the index, the fund managers make sure that those physical shares are also in the fund; that is, they buy the underlying assets, be they stocks, bonds or silver nuggets.