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As stock market benchmarks go, few are as popular and compared with than the Standard & Poor's (S&P) 500 Index.

The S&P 500 Index was created in 1957. It is a cap-weighted index consisting of 500 large-cap U.S. stocks listed on either the New York Stock Exchange or NASDAQ. According to S&P, assets invested in products indexed to the S&P 500 total nearly $1 trillion, a figure that has increased as more investors have embraced indexing as an investment strategy.

And that growing acceptance seems justified. According to fund analyst Deborah Fuhr, 81.2 percent of active large-cap managers in 2011 didn't beat the S&P 500. So basically you can invest in a managed mutual fund that charges a 1% or 2% fee or a passive exchange-traded fund with a fee of 0.5% or less, and have no greater opportunity for higher returns.

Exchange traded funds are investment funds, similar to mutual funds that trade on stock exchanges. The difference between an ETF and a mutual fund is that an ETF allows investors to trade throughout the trading day, much like a stock, while mutual funds can only be traded at the end of the day based their net asset value. Also unlike mutual funds, ETFs typically do not have sales loads or investment minimums.

Introducing S&P 500 SPDR

The first ETF linked to the S&P 500 was S&P 500 SPDR (NYSEARCA:SPY), which was founded in 1993.

Shares of SPY are currently valued in the mid $150s, with a price-to-earnings ratio of 14. The price has climbed from a low to $127 in May 2012 to a 52-week high of $159.71 set in mid April. As of mid April, the fund's year-to-date return was 11.03%, its one-year return was 17.43%, its five-year return was 5.15% and its 10-year return was 8.02%. The fund has a miniscule expense ratio of 0.09%. Its current dividend yield is 2.18%

Its largest holdings are all recognizable blue-chips, with its top 10 consisting of, in order, Apple (NASDAQ:AAPL), ExxonMobil (NYSE:XOM), General Electric (NYSE:GE), Chevron (NYSE:CVX), Google (NASDAQ:GOOG), IBM (NYSE:IBM), Johnson & Johnson (NYSE:JNJ), Microsoft (NASDAQ:MSFT), Procter & Gamble (NYSE:PG) and AT&T (NYSE:T). Its sector weightings are as follows: financials (16.82%), technology (15.51%), consumer services (12.78%), health care (11.6%), industrials (11.58%), consumer goods (11.07%), oil and gas (10.86%), and the remaining sector holdings all accounting for less than 4%.

SPY's Structure

Despite the fact that it lacks exposure to small-cap stocks, SPY has had more than a 99% correlation with the broad U.S. market and a 90% correlation to developed international stocks.

With assets of about $128 billion, SPY is one of the largest and most widely traded securities in the world. It is structured as a Unit Investment Trust (UIT). A UIT is an exchange-traded mutual fund offering a fixed, unmanaged portfolio of securities. UITs must fully replicate their underlying index, and are restricted from lending out securities that make up their portfolio.

According to SPYs prospectus, the ETF pays dividends four times annually, on the last business day of April, July, October and January. Because SPY is a UIT, the fund cannot reinvest those dividends. Instead, it must hold them in cash until they are scheduled to be distributed to SPY shareholders.

SPYs proponents believe the ETF is appropriate for investors seeking broad exposure to U.S. markets. Because of its link to the S&P 500, it focuses on large-cap stocks, yet is highly diversified with exposure to both growth stocks and value equities. Moreover investors do not have to worry about individual company specific factors such as performance, management, future prospects and valuation.

Other S&P 500 ETFs

Two other ETFs that also seek to mirror the S&P 500 Index:

iShares S&P 500 Index Fund (IVV)

Launched in 2000, IVV has the same 0.09% expense fee as SPY, and has identical company and sector weightings within its holdings. The key difference between IVV and SPY is that the former has an open-ended structure, providing more flexibility to the fund manager. Though it generally replicates the underlying index very closely, IVV is permitted to use derivatives, portfolio sampling strategies, and lend out portfolio securities to generate additional income. It also allows for the immediate reinvestment of dividends, potentially resulting in enhanced returns during bull markets.

Vanguard S&P 500 ETF (VOO)

This fund was founded in September 2010. It has a lower expense fee than the other two at 0.05%. Its holdings differ slightly, as it is more weighted in technology (16.45%) than the others. The key differentiator of this fund is that Vanguard maintains a patent that allows it to offer ETFs as share class within larger index funds that also offer retail and institutional share classes, which accounts for its lower expense ratio. Its structure also has added tax benefits, as Vanguard can sell high cost-basis securities to generate a capital loss to offset capital gains within the fund.

ETFs have also been created that are loosely linked to the S&P 500 with some key variations. Examples of those include:

PowerShares S&P 500 High Beta Portfolio (NYSEARCA:SPHB) holds 100 stocks from the S&P 500 Index deemed to have the highest sensitivity to market movements over the trailing 12-month period.

PowerShares S&P 500 Low Volatility Portfolio (NYSEARCA:SPLV) holds 100 stocks from the S&P 500 Index deemed to have the lowest realized volatility over the trailing 12-month period.

Guggenheim S&P 500 Pure Growth ETF (NYSEARCA:RPG) contains only S&P 500 companies with the strongest growth characteristics.


Disclosure: I have no positions in any stocks mentioned, and no plans to initiate any positions within the next 72 hours.

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Source: SPY: A High Quality, Diversified Investment