ETF Update - Don't Forget Your Dividends

Our S&P 500 ETF holds large and mid-sized companies, and it outperformed our Russell 2000 small cap ETF during the week.  Both of these ETF’s are very low cost, and add important diversification to our Blue Harbinger 15 and to our Lazy Person Portfolio.

Important to note, the S&P 500 ETF pays dividends at the end of each January, April, July and October, which means its dividend payment will be showing up soon if it’s not already in your account.  If you don’t need this dividend for your own personal spending purposes, then it is important to reinvest the cash received so it doesn’t add up and drag down the returns of your account over the long term.

Ideally, we want zero cash in a long-term investment account, but generally speaking it is not the end of the world if you have 1% cash in your account.  But if you accumulate much more than 1% then you should really think about getting that invested as soon as possible.  As a reminder, most discount brokers (E-Trade, Scottrade, TD Ameritrade) offer automatic dividend reinvestment programs, and it’s a good idea to take advantage of these programs if you are a long-term investor and don’t need the cash right away.  However, if you do need the cash then it’s always especially nice to see those dividends come rolling in quarter after quarter.

You can read our complete Russell 2000 Small Cap ETF thesis and research report here, and you can view the same for our S&P 500 SPDR ETF (SPY) here.

S&P 500 ETF (SPY) - Thesis

SPDR S&P 500 ETF (SPY)
Expected Return: 8.5% per year
Expected Volatility: 16.0% per year
Rating: BUY

Thesis:
As long-term investors, we believe the equity markets will increase over time, and the SPDR S&P 500 ETF (SPY) offers reliable exposure to equity market returns while avoiding the many pitfalls that are common among other ETFs and among other equity investments in general.

Holdings:
SPY generally holds all of the securities in the S&P 500 Index (it may omit a few during transitional periods, but not enough to significantly impact performance).  The index is one of the most commonly followed equity indices in the world, and many consider it one of the best representations of the U.S. stock market, and a bellwether for the U.S. economy.  Unlike other ETFs, SPY does not hold risky derivative instruments such as futures and swaps.  The performance of SPY has historically matched the performance of the S&P 500 index very closely, and it should continue to track closely in the future because it has essentially the same holdings as the index (investors cannot purchase the actual index, and SPY is the next best thing).

Volume and Liquidity:
SPY is the world’s largest ETF, and the world’s most highly traded ETF and equity security.  This scale has two significant benefits to investors.  First, because of the volume and liquidity, the bid-ask spread is small (the bid-ask spread is the difference in price at any given time for someone buying the security and someone selling it.  There is a difference because the middle man takes a very small cut).  A small bid-ask spread is good because it saves you money when you trade.  Second, SPY trades very close to its net asset value (NAV) because of the large volume and liquidity.  NAV is the actual value if you add up the value of all the securities held within SPY.  For many less liquid ETFs, the NAV may vary from its actual market price (the price the ETF trades at in the market).  This makes SPY much less risky for investors compared to other ETFs that may vary widely in price versus NAV.  Additionally, small investors don’t have to worry about some big investor coming in, buying or selling an enormous amount of SPY, and subsequently adversely moving the market price away from its NAV because the volume of SPY is already so great that this risk is essentially non-existent.

Low Fees:
The net expense ratio on SPY is currently less than 10 basis points (0.0945%).  This is extremely low for an ETF and extremely good for investors because it allows them to achieve better returns on their investment.  For comparison, mutual funds (a common competitor to ETFs) may charge 1-2% per year, and they tend to deliver worse performance over the long-term.  Additionally, there is no expensive sales charge or separate investment advisor fee because SPY can be purchased directly through a discount broker (e.g. Scottrade, E*TRADE, TD Ameritrade, Interactive Brokers, etc.).  The discount broker may charge you a one-time trading fee of $8 or less, but this is much better than the 2-5% sales charge/management fee you’d get charged by a full service financial advisor.  Additionally, there is no hidden 25 basis point (0.025%) annual 12b-1 fee paid to someone for “servicing your account.”  The bottom line here is that SPY is a very low cost way to get great exposure to the equity market and to build considerable wealth over the long-term.

Dividend Reinvestment:
One last point of consideration, SPY pays a quarterly dividend (around 2.0% per year), and this dividend is NOT automatically reinvested back into SPY (this is standard protocol for ETFs and stocks).  This mean you’ll build up a cash balance in your account if you don’t withdraw it or manually reinvest it.  As a long-term investor, cash is generally a drag on investment performance.  Unless you plan to withdraw and use the cash, we highly recommend you develop a process to reinvest it.  Most discount brokers (Scottrade, Interactive Brokers, etc.) offer automatic dividend reinvestment programs.  We highly recommend you sign up for these programs to avoid the situation where cash builds up in your account and becomes a drag on your long-term investment performance.  Reinvesting dividends is important.

Conclusion:
SPY is a very low cost, relatively low risk, security that allows investors to build significant wealth over the long-term.  We consider SPY to be a basic building block for long-term wealth, and we rate SPY as a “Buy.”  For more information, you can view the SPY fact sheet here.