Ferri: You Can Do Better Than The S&P 500

The S&P 500 is perfectly fine, but index investors can choose a better fund.

Reviewed by: Richard Ferri
Edited by: Richard Ferri

The S&P 500 is perfectly fine, but index investors can choose a better fund.

I’m an index fund investor, but I don’t invest in S&P 500 index funds. It’s not the type of index I want in my portfolio, unless I’m in a pinch. Here’s why.

The S&P 500 is arguably the most important stock market index on the planet. It represents the free-float value of 500 major corporations primarily domiciled in the US and gives investors an idea of the overall movement in the US equity market. The index is computed by using weighted market capitalization and it is continually updated throughout the trading day.

The S&P 500 has the distinction of being the first index to be tracked by a publicly available index fund. The Vanguard 500 Index Fund (ticker: VFINX) began operations on August 31, 1976. Investors only entrusted $11 million to the fund during the initial offering, according to John Bogle, Vanguard’s founder. VFINX became the largest US equity mutual fund in existence at one point in the late 1990s.

In 1994, the first commercially successful exchange-traded fund (ETF) was launched in the US. It also tracked the S&P 500. Today, the SPDR S&P 500 ETF Trust (ticker: SPY) is the largest ETF traded on the market by assets.

There is over $5 trillion benchmarked to the S&P 500 index in some form including derivatives, according to the company website, with direct index assets approaching $2 trillion, according to an interview I did with David Blitzer, managing director and chairman of the S&P Dow Jones Index Committee. He has the overall responsibility for index security selection in the S&P 500 and many other indexes at S&P Dow Jones.

With so much money tracking the S&P 500 index, why would I choose not to invest in it? It’s not that I believe the index is flawed; to the contrary, the S&P 500 is a fine benchmark and the companies in the index are probably the most liquid in the world.

The reason I’m not an S&P 500 investor is because my goal is different from S&P. They’re trying to capture the return of large leading industries in the US economy; I’m trying to capture the return of the US stock market. There is a slight difference.

The 500 constituents that make up the index represented about 80 percent of the US equity market by capitalization, according to S&P. In contrast, the total US stock market includes nearly 4,000 stocks, according to the Center for Research in Securities Prices, better known as CRSP. Since I’m trying to capture the return of all stocks, I prefer a total stock market index fund over one that tracks the S&P 500.


The Vanguard Total Stock Market Index (ticker: VTSMX) holds 3,770 stocks and captures over 99 percent of the US equity market by capitalization. It digs deep into the mid-, small- and micro-cap market space. This makes VTSMX a better choice for indexers because it provides a complete foundation for all US equities in a portfolio.

Greater exposure to small-cap stocks has made a difference in performance relative to VFINX. According to Morningstar, a $10,000 investment in VTSMX at its inception on April 27, 1992, would have grown to $77,317.94 by August 24, 2014, while the same amount invested in VFINX over the same period would have grown to $74,581.13.

A total stock market index fund can be used in two ways: as the only US equity holding in a portfolio or as the core holding with satellite positions. In a core satellite approach, an investor chooses to magnify portions of the total market, such as increasing real estate exposure through a REIT index fund or “tilting” to small-cap value stocks. The overlap will shift the risk and return dynamics of the portfolio. See To Tilt or Not to Tilt for more details.

Don’t get me wrong, I’m a big fan of S&P 500 index funds and recommend them in a pinch. Many 401(k) plans only include just one low-cost index fund among dozens of high-cost active funds. The token fund almost always tracks the S&P 500. I’ll often go so far as to recommend the S&P 500 index fund be used as 100 percent of an equity allocation in a 401(k) when all the other equity funds are unreasonably high-cost actively managed products.

The 100 percent S&P 500 approach may appear to lack diversification, but it makes sense because the high cost to diversify in many 401(k) plans overwhelms any benefit derived from it. I do recommend to an investor using this approach to purchase international and small-cap stock index funds or ETFs outside their 401(k) to achieve overall diversification.

An S&P 500 index fund is fine in a pinch, but I’m a total market index guy at heart. The expense to invest in a total market index fund is no higher than an S&P 500 fund and there’s more diversification. I’m not alone in my way of thinking. Over the years, Vanguard investors have placed twice the amount of assets in total US stock market index products than in S&P 500 index products.


For a full list of relevant disclosures, click here.


Rick Ferri, founder of Michigan-based Portfolio Solutions, is a widely recognized index investor and the author of several books on index investing.


Richard Ferri, CFA, is founder and managing partner of Portfolio Solutions. He directs the firm's research and education, and is head of the Investment Committee. Ferri writes regularly for the Wall Street Journal, Forbes, the Journal of Financial Planning and his own blog at www.RickFerri.com.