Happy birthday to the "O.G." of exchange-traded funds.
If I told you that possibly the world's best-performing, long-term equity portfolio turned 30 this past weekend, what would you think I'm talking about?
I'll give you a hint: It puts the 60 in just about every 60/40 allocation strategy. Another hint: It routinely crushes hedge funds. Final hint: It was the first ETF launched in America.
The answer? The SPDR S&P 500 ETF Trust (SPY) . The fund was first launched with a 20 basis point expense ratio which has since been lowered to 9.45. While there are cheaper copycat funds out there, SPY has been using its first-mover advantage for decades to retain and grow assets.
There are a whole bunch of articles out there talking about this milestone, its impact on the investing landscape, and generally celebrating how far we've come since SPY's 1993 launch. So I won't rehash all that here. Regular readers know that the one thing I like to do is explain how strategies work and that's what I'll try to do here.
Some of you might be thinking, "what does he mean? SPY is just the top 500 U.S. companies by market cap. What's to figure out?" If you are in this camp, hold on because while you and many assume that SPY is the original passive investment, nothing could be further from the truth. Let's take a look.
Putting SPY Under the Microscope
As with any index-tracking fund, the best place to learn about the strategy is in the index methodology. The index in question of course is the S&P 500 Index, or "SPX." The S&P has many methodologies that cover everything from corporate action handling to the mathematics behind index calculation to the process to adjust for free float (shares determined to be free and available to trade) and even the Global Industries Classification Standard (GICS) they use to classify and categorize every listed equity. Luckily, they also have a methodology that runs through all the steps they take to select index constituents. If you do follow the link, be warned that the document covers the S&P Total Market Index and all of its subsets, one of which is the S&P 500.
As mentioned earlier, this index family "is designed to measure the market performance of U.S. domiciled stocks trading on U.S exchanges." SPX "measures the performance of the large-cap segment of the U.S. market."
While both the index name and the methodology state the index "is composed of 500 companies," S&P includes both share classes for Alphabet ( (GOOG) , (GOOGL) ), Fox News ( (FOXA) , (FOXB) ), and News Corp ( (NWSA) , (NWS) ) Bringing that total holding number to 503. Interestingly, because the index is market cap weighted, each share class is weighted by its individual market capitalization, so there's no double counting. Also, because the main difference between these share classes has to do with shareholder voting rights, these shares do trade differently.
Bear with me for the next paragraph. Eligibility requirements include that a company must file a annual report. Things start to get a little squishy in the next requirement, which is that company fixed assets and revenues must be at least half U.S.-based. If revenues do not meet this location-based threshold, then fixed assets can be used to make this determination. If there isn't enough reported information to determine fixed asset geography, then the geographic revenue breakdown is used. Finally, there is a list of eligible exchanges that include all equity venues for the New York Stock Exchange, Nasdaq, and Cboe. Shares that trade Over-The-Counter are ineligible for inclusion. Eligible company types are limited to corporations, including equity and mortgage real estate investment trusts. The list of ineligible entities and share types is long and includes preferred stocks, American Depositary Receipts, special purpose acquisition companies, business development companies and ETFs.
There is a market cap minimum that is currently set at $12.7 billion and is reviewed quarterly. Companies must also have at least 50% available free float, meaning that no more than half of shares can be tied up with insiders or individual outsider positions of 10% of outstanding shares or more.
If an initial public offering is $2 billion or more in market cap, it can be fast-tracked into the index.
All of these rules sound like a lot, and they are, but, these are just the rules that guide the development of the universe of companies that are eligible for inclusion. The real magic happens on page 11.
What are the final selection criteria that are used to fill all slots in this standard bearer of measuring the American economy? How does S&P go about choosing these 500 names that ultimately become the index that over $13.5 trillion of assets track, not to mention open interest in the options and futures markets, as well as Volatility Index and all of its listed and OTC derivatives?
Sector weights are taken from the total market index, meaning that each sector in SPX reflects that sector's overall weight in the market. As for individual names, believe it or not, the secret sauce is the index committee. From the methodology:
"Constituent selection is at the discretion of the index committee and is based on the eligibility criteria."
Further, while many of the other indexes in the methodology have stated reconstitution and rebalance schedules, there is nothing specific to SPX. In other words, the $13.5 trillion investment management gorilla of passive, index-based investing is, by its own definition, an actively managed portfolio.
Wrap It Up
In 2019, the then-head of the S&P Index Committee retired. It was soon after that Tesla (TSLA) was added to the SPX. My take on that addition was that the discipline and experience that Mr. Blitzer brought as chairman of that committee had left with his departure. I'm not saying that the reign of SPX is over, but my guess is that over time this index will start to lose some of its reputation for being unbeatable. Still, Newton's first law of motion tells us that with 66 years of index history and the trillions of assets tracking this index, SPX will be a force in the markets for a long time to come.