Structure is Everything
When ETFs were first being created they were called Unit Investment Trusts (UITs). UITs are structured in a way that the investors in the fund actually can redeem the underlying holdings or have it done automatically on the UIT’s termination date. For an ETF investor, redeeming the underlying securities is reserved only for market makers and is prohibited to individual investors. The units can only be created and redeemed in units of 50,000. ETFs filed as UITs are held in trust and units of the trust are sold and traded.
State Street’s “Spider”
The SPDR fund, SPY, is the oldest and most traded ETF in the US. SPY is set up as an UIT and State Street is the trustee of the fund. SPY has no termination date and is continuously held until the ETF shares are sold. What is notable about the fund is that SPY sells at 1/10 of the index price.
The manager of SPY must fully replicate the S&P 500 at all times. The manager cannot lend shares as a way to generate revenue. Dividends must be held in cash until paid to shareholders. All Fund Expenses (0.08%) are paid from the dividends earned by the underlying holdings.
Because SPY’s net asset value (NAV) always closely mimics the S&P 500 index it is very reliable and suitable for options trading. Without this strict structure, price deviations from the index may disrupt an option strategy. Any strategy depending on the ETF tracking very closely S&P 500 should rely on SPY. Because of that reason SPY is a favorite, relative to IVV for intraday trading. Traders and strategy investors demand no surprises other than what is reflected by the underlying stocks or trading on the ETF. In the same way, long term investors are not as concerned with small price differences.
Dividends that are earned from the underlying equities in SPY are held in cash until paid out on a quarterly basis. Since dividends cannot be reinvested, a ‘dividend drag’ is created where during climbing markets dividends are not reinvested to add to the return of SPY. During descending market periods holding the dividends in cash is more profitable.
Barclay’s iShares, a leading ETF provider, offers IVV as a way to track the S&P 500. The open-end structure of IVV gives the portfolio manager more freedom. For instance, IVV can loan shares and receive interest. IVV is not required to hold all 500 of the underlying stocks in the index, although it usually does. The fund can also use an optimization approach to best represent the index. All these freedoms allow IVV to reduce the cost of operation to investors. The most important difference between IVV from SPY is that as dividends are earned by the underlying equities, IVV reinvest them into the index until they are to be paid out quarterly. This will increase the return in an upward moving market or the opposite in a downward market.
Option trading on IVV is available; however trading volume is not as competitive as SPY. In highly volatile markets, we have not seen the option prices move with price fluctuations of IVV. For a protection strategy this may be ok, but for more speculative trading this could cause a problem.
The difference between SPY and IVV is fairly straight forward; do you want your dividends reinvested into the index, or held in cash. Since 2000 Barclays and State Street have competed for assets and continually lower expense ratios. This competition has made the two ETFs some of the lowest cost funds available. We will note that SPY has the lower annual expense ratio at .08% and IVV closely trails at .09%. However SSgA writes in small print on the SPY section of their website: “agreed to waive a portion of its fee until February 1, 2009, but may thereafter discontinue this voluntary waiver policy.” This indicates that the small price tag on SPY may just be a bait and switch tactic. We suspect that as the market recovers and money flows back into the market that both fees will continue to decrease. When you are ready to invest in a large cap index ETF, you are now equipped to make the right choice for you.
Casey T Smith
Research by Kyle Waller