While FAANG stocks have lost much of the bite that drove the S&P 500 outperformance last year, that doesn’t mean S&P 500 ETFs are being held hostage by a handful of tech stocks.
ETFs with alternative strategies that don't mirror market cap weighting are outperforming the traditional S&P 500 Index. This reverse indexing, if you will, is having a significant impact on returns this year.
The SPDR S&P 500 Trust (SPY) is the largest ETF by assets under management, with more than $353 billion in assets. One alternative to the market-cap-weighted SPY is the Arrow Reverse Cap 500 ETF (YPS). This fund weights holdings inversely to their market cap, allocating more weight to the smaller members of the index.
SPY Vs YPS Portfolio Comparison
(For a larger view, click on the image above)
What Drives Performance
By using our ETF Comparison Tool, we can see that the difference in weighting schemes can have a significant impact on portfolio characteristics for each ETF.
The market-cap-weighted SPY leans heavily toward technology, at more than 33% of the portfolio. Meanwhile, YPS has the greater exposure to financials, with tech making up just 12% of the portfolio.
The difference in the number of holdings between the two funds can be explained through their investment strategies. Per SPY’s prospectus, “minor misweighting generally is permitted” if transaction costs would exceed the expected impact.
YPS has a similar disclaimer within its prospectus, noting that the fund will generally use a replication strategy, but may use a representative sampling strategy. This means the fund can invest in a sample of the securities of the index as long as the fund remains aligned with the risk, return and other characteristics of the index as a whole.
This can lead to a discrepancy in the number of holdings compared to the index, especially for the smallest holdings, with minimal impact on returns.
SPY Vs. YPS 2020
But performance is where the rubber meets the road, and a look at the last two years is a tale of two different return sets. With these differences in portfolio composition, it is not surprising that SPY outperformed YPS in 2020 by more than 10%.
The largest names in the index, such as Apple, Microsoft and Amazon, vastly outperformed the S&P 500.
(Use our stock finder tool to find an ETF’s allocation to a certain stock.)
Financials, on the other hand, underperformed the broad market, as companies such as banks were battered by falling interest rates, punishing YPS more so than SPY because of weightings.
SPY Vs YPS 2021 YTD
However, 2021 has been a different story so far. Compared to YPS, SPY is underperforming this year as tech stocks have struggled. Some of the same companies that led the market last year are this year’s laggards.
Apple Inc. currently the largest holding in the S&P 500, has struggled to eke out a positive return for much of the year even though the broad index is up double digits. And as last year’s tech rally drove up the weighting to these holdings, it has further amplified the negative impact these names had on the portfolio as these companies have struggled.
Market Cap Matters
In addition to sector differences, performance has also been driven by market cap. Midcap names tend to be more sensitive to investor sentiment about the U.S. economy. On the other hand, the larger, multinational companies that make up a large portion of the S&P 500 are more sensitive to global growth expectations.
As the weighted average market cap of YPS is only slightly higher than that of many U.S. midcap ETFs, it stands to reason that this weighting methodology would do well in environments like the one we are in.
The U.S. is reopening faster than international countries, and the expected growth of the U.S. economy is projected to be faster than that of the rest of the world. That benefits midcap and small cap companies that derive the majority of their revenue in the U.S.
Another Way To Skin The S&P 500
In addition to market cap weighting and reverse market cap weighting, another way for investors to play this segment of the market is to use an equal-weight ETF such as the Invesco S&P 500 Equal Weight ETF (RSP) .
As the name suggests, this ETF gives equal weight to all constituents regardless of market cap. This reduces the exposure to the largest cap names but avoids tilting the portfolio toward the smaller cap names. RSP, too, is outperforming SPY.
Performance this year has been in between that of SPY and YPS, which is to be expected, as the weighting methodology ensures that neither larger nor smaller names are given precedence.
The Big Picture
Comparing these three ETFs since common inception, SPY still comes out ahead, even in light of its recent underperformance.
Though certain time periods might prove to be friendlier to alternative weighting methodologies, SPY’s performance so far remains on top over the long term, though data is limited since YPS’ launched less than four years ago.
Charts courtesy of StockCharts.com
SPY’s Clear Benefit: Cost
Though each weighting methodology has its pros and cons, SPY’s dominance in terms of AUM gives it one clear benefit. The ETF has an expense ratio of 0.09%—less than half the cost of the other options. And since it is so heavily traded, with an average daily volume of nearly $26 billion, the average spread is essentially 0.00%.
Compare that to YPS, with an expense ratio of 0.29% and average spread of 0.21%, and RSP, with an expense ratio of 0.20% and average spread of 0.01%, and you can see how SPY benefits from its sheer size.
Investors can control cost, which should be as much of a factor in investment selection as last year’s returns.
For more information on S&P 500 ETFs, check out our S&P 500 ETFs channel.
Contact Jessica Ferringer at [email protected]