Large Cap ETF Showdown: SPY vs. FEX

by on August 22, 2011 | ETFs Mentioned:

Despite bleeding billions of dollars during the recent chaotic stretch on Wall Street, the S&P 500 SPDR (SPY) is still the largest exchange-traded product in the world; with more than $75 billion in assets, the popular fund is larger than the GDP of many countries. A big chunk of the assets in SPY are held by traders with a relatively short time horizon; the high turnover of shares in SPY–about 35% of the shares outstanding change hands everyday–highlights the appeal of this vehicle to active traders who measure holding periods in minutes and hours [see also Gold SPDR Close To Overtaking SPY As Largest ETF In The World].

Beyond SPY

But SPY also has appeal as a portfolio “building block” that is consistent with longer-term strategies. This ETF offers exposure to large cap U.S. stocks, an asset class that is at the core of many long-term, buy-and-hold portfolios. A large number of investors seeking large cap exposure use SPY to satisfy their demands. But recent years has seen the ETF industry innovate to offer a line of competitors to the ETF king. Now, investors can gain large cap exposure using a number of weighting methodologies like equal, RAFI, dividend, and more. There are also alternatives that utilize quant-based methodologies which are designed, essentially, to outperform the S&P 500.

Quant-based strategies have been around some time, as a number of exchanged traded products have opted to choose and weight their holdings based on methodologies that include evaluation of various metrics. Some measure book value of firms, while other look at cash flow, and still others focus on different metrics entirely. The drawback that many investors find with these quant funds is the high expenses they charge; for some, it is hard to justify paying 50 basis points or more when SPY charges just nine [see also Six ETFs Up 45% Or More During The Recent Crisis].

Some investors are skeptical of ETFs that blur the line between active and passive management, offering up techniques that aim to generate alpha at a much higher price tag than their simpler cap-weighted counterparts. Those who believe in full efficiency of markets scoff at the idea that a quantitative methodology can consistently generate sufficient excess returns to justify a hefty expense ratio. But with many of these products now well into their fourth year of operations, there is evidence to suggest that some accomplish that challenging objective quite well. Below, we outline a quant-based ETF that may have appeal as an alternative to SPY, to see how this strategy stacks up to its SPDR counterpart:

Large Cap Core AlphaDEX (FEX)

FEX is one in a long line of products that utilizes the AlphaDEX methodology, a strategy developed by First Trust. The ETF, using its quant methodology, selects stocks from the S&P 500 to make up its underlying holdings. The AlphaDEX strategy ranks stocks based on growth factors that include recent price appreciation (over various time periods), sales to price and one year sales growth, and separately on value factors including book value to price, cash flow to price and return on assets [see more on FEX's fact sheet]. FEX features about 370 individual holdings, many of which are also found in more traditional large cap U.S. equity funds (it should be noted that the top ten assets accounting for just 5.2% of the entire fund, indicating a nice level of balance in the portfolio). On the other hand, SPY has 501 holdings, but nearly 20% of its assets are dedicated to the top ten holdings.

From a sector standpoint, the fund spreads its assets to all nine major segments, but tends to favor industrials and leave out real estate; SPY favors technology and also steers clear of real estate. FEX is dominated by large and mid cap funds, though giant and small caps get some representation as well. The fund trades hands about 140,000 times daily, and while it is no match for SPY, it is still relatively liquid. But FEX takes a hit when it comes to expenses, as its fees of 70 basis points far outweighs the cost of SPY. To justify if these expense are worth it or not, it may be useful to compare the performances of these two products over the last few years to see if the AlphaDEX strategy truly does add alpha:

SPY vs. FEX Returns
Ticker YTD* 2010 2009 2008
SPY 3.75% 15.02% 26.31% -36.70%
FEX 3.31% 20.67% 36.83% -38.73%
*Data as of 7/31/2011

As the table above illustrates, FEX has more than justified its additional fees; the fund has outperformed SPY by a significant margin in recent years. More specifically, FEX has performed well in bull markets, while SPY does better in bear or unstable markets. Both 2009 and 2010 saw strong market years, in which FEX considerably outperformed SPY. But 2008 and 2011 featured either unstable or abysmal markets, in which case, SPY held its ground a little better than its quant competitor. Since the beginning of 2008, the alpha generated has more than covered the additional fees; FEX has beaten SPY by about 14% over that period [see also Closer Look At Quant-Based ETFs].


The obvious drawback to FEX is its expense ratio, but when considering that it outperformed SPY by well over 1,000 basis points in the last three and a half years, 0.70% is just a drop in the bucket. FEX features less holdings overall, but has a better diversity among the 370 or so that it does hold, which may appeal to certain investors. Consider that FEX gives no single holding a higher weight than 0.55%, while SPY’s top security accounts for more than 3.3% of the fund. The two funds weight market segments very differently, which is an important characteristic to observe before investing in either fund [see also Three Intriguing Alternatives To Popular ETFs (SPY, XLF, FXI)].

In the ETF industry, bigger isn’t always better. A huge base of assets may be more indicative of a long operating history or impressive brand recognition than it is of the efficiency of a product. Many of the better ETFs out there are flying under the radar of most investors, attracting far fewer assets than the “super tickers” that are widely known and used. Digging a bit deeper can sometimes be a very rewarding endeavor–as those who have used FEX in place of SPY can attest.

Disclosure: No positions at time of writing.