Why I Don't Buy and Hold the SPDR S&P 500 ETF Trust (SPY)

You've probably heard of the SPDR S&P 500 ETF Trust (SPY)—launched in January 1993, it's the oldest U.S.-listed ETF and currently one of the largest, boasting over $549 billion in assets under management as of August 8, 2024.

It's become nearly synonymous with "the market" for many investors; I often find myself checking SPY’s performance to gauge how U.S. equities are doing, rather than looking directly at the actual S&P 500 Index (GSPC or SPX).

And if you spend any time on investment forums like Reddit, you'll see plenty of advice pushing new investors to "buy and hold SPY," especially after they've experienced a portfolio setback and are looking for a safer bet.

However, while this advice isn't exactly wrong, it can be somewhat misguided. Indeed, SPY is an outstanding ETF, known for its liquidity and as a favorite among active traders and those using options.

But for those looking to simply buy and hold the S&P 500 as part of a long-term investment strategy, SPY might not be the best option. Here’s why.

Why not SPY: cash drag

This part delves a bit into ETF industry terminology, so bear with me. The key issue here involves SPY's legal structure as what's known as a Unit Investment Trust (UIT), a format that was more common when SPY was launched back in 1993.

At that time, ETFs were a new concept, and the UIT structure was chosen for SPY due to regulatory and operational conveniences of that era. While this distinction may not seem significant to most investors today—who may simply see SPY as another ETF—it does have one crucial implication: cash drag.

Unlike more modern ETF structures, a UIT like SPY cannot internally reinvest the dividends it receives from the companies throughout the year. Instead, it must hold these dividends in cash until they can be distributed to shareholders.

In contrast, the S&P 500 index, which SPY aims to track, calculates its total return assuming dividends are reinvested immediately. This means that between the quarterly distribution periods, any dividends paid to SPY by its constituent companies just sit idle as cash.

This creates a cash drag: in a bull market, where reinvested dividends could be compounding, holding cash instead can drag down performance. Conversely, in a bear market, holding cash could actually be beneficial as it avoids further losses. But, bull markets are more common than bear markets.

While this cash drag is small, it does contribute to SPY's tracking error with the S&P 500. This is the discrepancy between the performance of the ETF and the index it tracks, where a lower tracking error is typically preferable because it means the ETF is more accurately replicating the index's performance.

Despite this, the cash drag issue is just one of several reasons why SPY might not be the best choice for a buy-and-hold strategy, as we'll see shortly.

Why not SPY: higher fees

The main reason to reconsider using SPY as a buy-and-hold investment in the S&P 500 is simply that there are competitors offering nearly the same liquidity and scale, but at a significantly lower cost.

SPY charges an expense ratio of 0.0945% per year, which translates to about $9.45 in annual fees for a $10,000 investment. While this is still very competitive compared to most mutual funds and many ETFs, it's not the most cost-effective option available.

Consider the alternatives: both the Vanguard S&P 500 ETF (VOO) and the iShares Core S&P 500 ETF (IVV) charge an expense ratio of just 0.03%—which amounts to only $3 per $10,000 invested.

While this difference might not seem substantial at first glance, over time and as your investment grows, these savings can significantly impact your overall returns. In the long run, as is typically the goal with a buy-and-hold strategy, a SPY investor would likely underperform compared to someone invested in VOO or IVV, all other factors being equal.

SSGA, the company behind SPY, is aware of this competitive disadvantage. In response, they offer the SPDR Portfolio S&P 500 ETF (SPLG), which provides the same exposure to the S&P 500 but at a lower price per share and an even lower expense ratio of 0.02%.

The final word on SPY

I want to make it crystal clear that I personally have nothing against SPY—in fact, I actively use it, just not as a buy-and-hold investment.

For me, SPY is the go-to ETF when I need to engage in options trading, whether it's executing covered calls, cash-secured puts for generating income, or using collars to hedge my long equity exposure.

In terms of trading, SPY is unmatched. No other ETF can compete with it in terms of liquidity, which encompasses both volume and the tightness of the bid-ask spread.

Moreover, the options chain available for SPY is exceptional, featuring daily expiring options and a very extensive range of strike prices with robust open interest. This breadth and depth make it possible to execute complex multi-leg strategies effectively.

However, these very factors that make SPY an excellent trading tool underline why it's not ideal for buy-and-hold strategies. For long-term investing in the S&P 500, ETFs like VOO, IVV, or even SPLG offer lower fees and are better suited to the needs of beginner investors looking to build wealth over time without the need for frequent trading.