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Friday, June 21, 2013 - 8:30am

Mutual funds are one of the great success stories in the history of financial services.

In 1970, just 360 funds existed in the United States, with assets under management at $48 billion. By the end of 2011, there were more than 14,000 mutual funds -- with assets of $13 trillion. Thanks to these funds, new classes of investors could access the market, and the financial services industry enjoyed huge gains.

But now, after decades of growth, the mutual fund industry is under attack. With bloated fee structures, insufficient transparency, ongoing conflicts of interest, and years of underperformance, the mutual fund industry is experiencing a tidal wave of capital outflows. Domestic equity funds lost $154 billion in assets in 2012 -- the fifth consecutive year the industry has had a net outflow.

What's driving the shift away from mutual funds? Exchange-traded funds, or ETFs.

Investors choose ETFs over mutual funds because they are less expensive, more transparent and provide enhanced tax benefits. (My colleague David Sterman highlighted the benefits of ETFs in a recent article.)

Among the most popular destinations for investors shifting away from mutual funds are S&P 500 index ETFs. With almost 90% of managed mutual funds underperforming their benchmarks, S&P 500 ETFs have become a popular alternative because they are traded on an exchange like a stock and have lower management fees.

In fact, the SPDR S&P 500 (NYSE: SPY) ETF is the most popular ETF in the world, with assets under management of $137 billion. The iShares Core S&P 500 (NYSE: IVV) ranks fourth, with $42 billion in assets under management. Vanguard's S&P 500 ETF (NYSE: VOO) is in the top 30, with assets under management of $6 billion.

But even though these three S&P 500 ETFs are designed to track the leading equity benchmark, there are big differences between them. Here is a closer look at the three most popular S&P 500 ETFs and what every investor needs to know about how they differ.

SPDR S&P 500
This SPDR S&P 500 is one of the oldest and popular ETFs in the market, first listed in 1993. With average daily volume of 126 million, the SPDR S&P 500 is a popular destination for big institutional investors that need plenty of liquidity when deploying hundreds of millions of dollars into the market.

With an expense ratio of just 0.09%, SPDR S&P 500 is relatively low-cost in the ETF world, but it's more expensive than some of its S&P 500 peers.

One of the key distinctions of the SPDR S&P 500 ETF is that it's structured as a unit investment trust, which prohibits it from reinvesting dividends and holding securities not in the index, such as derivatives. Although this leads to slightly higher carrying costs, it also enables the fund to track its benchmark with great precision.

That has led to an active and highly liquid options market where derivatives traders demand tracking precision. SPDR S&P 500 also has a one-month delay between its ex-dividend date and the payment of dividends.

SPDR S&P 500 is a great option for large institutional investors that value a highly liquid market with the ability to absorb large trades. Its active, liquid options market also makes it a great destination for investors using derivatives.

iShares Core S&P 500 ETF
The iShares Core S&P 500 ETF is another superstar, with enough liquidity to absorb multimillion-dollar trades.

There are two primary differences between SPDR S&P 500 and iShares Core S&P 500. The first is that iShares has a lower expense ratio of 0.07%. The second is that iShares is allowed to use derivatives to track its benchmark, enabling it to closely replicate its benchmark while reducing expenses.

Another key feature of iShares is that it's allowed to reinvest dividends in the components of the S&P 500 until it is required to make a distribution to shareholders.

For regular investors who don't require mountains of liquidity for huge trades, iShares' lower expense ratio makes it a very attractive option. Its ability to reinvest dividends is also an attractive feature for investors who want to be fully deployed and limit cash balances in their accounts.

Vanguard S&P 500 ETF

The smallest of this group, the Vanguard S&P 500 ETF has an average daily volume of 1.2 million.

Vanguard has long been a market leader in low-cost investment products, and that philosophy shows up in this fund, boasting this group's lowest expense ratio at just 0.05%.

With the average expense ratio of a mutual fund clocking in at more than 1%, a low-cost ETF with an expense ratio of just 0.05% provides big benefits to investors. For a $1 million account, reducing fees by 1% annually saves $10,000. That $10,000 compounded for 30 years and returning just 4% annually would grow into $615,717.

Not only is Vanguard the lowest-cost option on the list, its structure has the potential to offer tax benefits.

Redemption request from various groups of shareholders gives Vanguard the option of selling high cost-basis securities to offset capital gains.

The Vanguard S&P 500 is a great option for investors focused on lowering costs and reducing fees. It also offers potential benefits for investors who want an opportunity to offset capital gains and reduce tax liability.

Action to Take--> Buying an S&P 500 index fund is both easy and inexpensive. Unlike mutual funds, ETFs are listed securities and can be bought directly through an exchange. They are also less expensive to purchase than mutual funds, which are usually $50 to buy or sell and may carry front- and/or back-end loads. But as listed securities, ETFs carry a low commission that is usually in line with executing a stock transaction.

This article originally appeared at
Why This ETF Is More Popular Than Any Other In The World...

P.S. -- These ETFs are about as simple as investments get. StreetAuthority's Amy Calistri has a similarly simple goal for readers of her Stock of the Month newsletter: Provide one quality stock pick each month, with in-depth analysis in plain English that investors can understand. Go here to learn more.

Michael Vodicka does not personally hold positions in any securities mentioned in this article.
StreetAuthority LLC does not hold positions in any securities mentioned in this article.

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