The S&P 500 is a popular stock market index for investors following the U.S. market. This stock market index is loved by retail and professional investors alike, both as a barometer of U.S. stock market performance and as a benchmark to compete against. Even Warren Buffet loves the index, famously using it to win a bet against a pool of hedge funds.¹

Investors looking to invest passively in the S&P 500 today can use a variety of exchange-traded funds (ETFs) that track the index. These ETFs offer low costs, high diversification, and simplicity.

An S&P 500 ETF can be a great way for Canadians to invest in a diversified portfolio of U.S. stocks. Interested in learning more about the S&P 500 and investing in it via ETFs? Let’s break it down.

What is a S&P 500 ETF?

Created in 1957, the S&P 500 is a famous market-capitalization weighted index that tracks the stocks of 500 large-cap, U.S. companies. The index tracks stocks from all 11 market sectors as selected by S&P Dow Jones Indices.² Combined, the stocks in the S&P 500 account for 80% of the total U.S. stock market by market capitalization.³

Because investors cannot invest directly in an index, they must resort to mutual funds or ETFs that track the S&P 500. These ETFs work by holding a “basket” of the underlying S&P 500 stocks according to their respective weights in the index at a given time.

By doing so, the ETF can track the price of the S&P 500 index. The difference between the actual return of the S&P 500 index and a S&P 500 ETF is known as “tracking error” and can be positive (if the ETF outperforms), or negative (if the ETF underperforms).⁴

In exchange for this service, investors who purchase a S&P 500 ETF pay a management expense ratio (MER). This is the percentage fee deducted annually from your investment to pay for the ETF manager’s trading, operational, administrative, and marketing costs. For example, a S&P 500 ETF with a MER of 0.10% would cost you around $10 annually for $10,000 investment.

Because some of the stocks in the S&P 500 pay dividends, S&P 500 ETFs will also pay periodic distributions. Typically, the ETF manager does this on quarterly basis by collecting and paying out the individual dividend payments from the underlying stocks.

However, any distributions from a Canadian-listed S&P 500 ETF will be reduced by 15% due to a foreign withholding tax on dividends U.S stocks. The only way to avoid foreign withholding tax is by buying U.S. listed S&P 500 ETFs or stocks and holding them in a registered retirement savings plan (RRSP).

Types of S&P 500 ETFs

Canadian-listed S&P 500 ETFs can also come in currency hedged and unhedged forms. When it comes to unhedged S&P 500 ETFs, changes in the USD-CAD exchange rate can affect their returns. There are two scenarios for unhedged S&P 500 ETFs:

1. If the USD appreciates against the CAD: Canadian listed unhedged S&P 500 ETF will gain additional value.
2. If the CAD appreciates against the USD: Canadian listed unhedged S&P 500 ETF will lose additional value.

Unhedged S&P 500 ETFs therefore have higher volatility as their returns are also influenced by changes in the USD-CAD exchange rate. To avoid currency risk, investors can buy hedged S&P 500 ETFs, which use derivatives called forwards to mitigate it. However, hedged ETFs tend to have higher tracking error due to the cost of currency hedging⁶.

Finally, there are more exotic Canadian listed S&P 500 ETFs that use derivatives like swaps or options to provide investors with greater income potential or leveraged and inverse exposure. These products often have higher fees, more risks, and greater complexity, and are best suited for advanced investors.

RELATED: Top Canadian ETFs

Top Canadian S&P 500 ETFs

The following Canadian listed S&P 500 ETFs have a combination of low fees, broad diversification, and high assets under management.

BMO S&P 500 Index ETF

ZSP is currently the most popular Canadian S&P 500 ETF with assets under management, or AUM of $9.52 billion. The ETF tracks the S&P 500 by investing in and holding the stocks of the index based on their current weightings.

Vanguard S&P 500 Index ETF

VFV is the second most popular Canadian S&P 500 ETF with AUM of $6.74 billion. Unlike ZSP, VFV uses a “fund of funds” structure by holding another US listed S&P 500 ETF for its exposure. VFV also comes in a currency hedged version, the Vanguard S&P 500 Index ETF (CAD-hedged) (TSX:VSP).

iShares Core S&P 500 Index ETF

BlackRock iShares offers XUS, which also tracks the S&P 500 using a fund of funds structure by investing in its US listed counterpart. Like Vanguard, BlackRock iShares also offers a CAD-hedged version of XUS, the iShares Core S&P 500 Index ETF (CAD-Hedged) (TSX:XSP).

Horizons S&P 500 Index ETF

HXS is a unique S&P 500 index ETF that does not hold any of the S&P 500 stocks or a US listed S&P 500 ETF. Rather, HXS uses a derivative called a total return swap to track the returns of the S&P 500. As a result, HXS does not pay a distribution, which makes it highly tax efficient.

Pros of investing in S&P 500 ETFs

S&P 500 ETFs have the following advantages:

• Low costs: S&P 500 ETFs are some of the cheapest ETFs available on the Canadian market.
• High diversification: S&P 500 ETFs provide Canadian investors with instant access to a portfolio of 500 U.S. companies from all sectors.
• Hands-off: Investors who buy an S&P 500 index fund no longer need to keep up to date on earnings reports or worry about managing individual stocks.
• Consistency: While past performance does not predict future performance, the S&P 500 has a long history, posting an annualized return of 10.07% since its inception in 1957⁷.

Cons of investing in S&P 500 ETFs

S&P 500 ETFs have the following disadvantages:

• High volatility: An S&P 500 ETF is a 100% stock investment. Historically, it has been more volatile than bonds or cash, and has lost substantial value during crashes like the 2000 Dot-Com Bubble, the 2008 Great Financial Crisis, and the 2020 COVID-19 Crash.
• Sector concentration: Around 25% of the S&P 500 ETF is currently in the technology sector, which can leave some investors overly exposed.
• Lack of small-caps: The market-cap weighted nature of the S&P 500 makes it very heavy in large-cap stocks. Currently, the S&P 500 excludes some 3,000 small-cap stocks included in the total U.S. stock market.
• Lack of international stocks: Investing only in large-cap U.S. stocks can cause investors to miss out on the returns of domestic Canadian stocks or international stocks, which can outperform when U.S. markets lag as they did from 1999 – 2009 during the “lost decade”⁸.

Are S&P 500 ETFs right for you?

The answer to this question always depends on your time horizon, investment objectives, and risk tolerance. In general, an allocation to S&P 500 ETFs is best suited for long-term, high-risk investors who are bullish on U.S. markets and large-cap stocks and looking for the lowest-cost investment.

Keep in mind that a S&P 500 heavy portfolio is an explicit bet on large-cap U.S. stocks continuing to outperform. While these stocks have performed well over the last decade, they have also underperformed in the past and their future performance is not guaranteed.

Therefore, investing only in the S&P 500 is a highly aggressive move best suited for investors who can tolerate the high volatility of a 100% stock portfolio. Other investors should consider an allocation to bonds or diversify internationally or domestically with Canadian stocks.

Sources:

1. AEI “Warren Buffett Wins $1M Bet Made a Decade Ago That the S&P 500 Stock Index Would Outperform Hedge Funds, and It Wasn’t Even Close”
2. S&P Global “S&P 500 Overview”
3. S&P Global “S&P 500 Factsheet”
4. Corporate Finance Institute “Tracking Error“
5. BlackRock “Understanding Foreign Withholding Tax“
6. Horizons ETFs “Currency-Hedged ETFs“
7. OfficialData.Org “Stock market returns since 1957“
8. AMG Funds “The lost decade revisited”