Updated: May 3, 2013 12:14PM
Originally published: April 29, 2004
What’s the market doing today? It’s a question I hear every day. I wonder what people mean when they ask that question. Are they wondering if the Dow Jones industrial average is up or down -- or the broader Standard & Poor’s 500 stock index?
People ask about the “market” because it’s sort of the thermometer of the American economy. So why don’t people just invest in “the market” instead of trying to pick stocks or mutual funds that will “beat” the market? It’s really very easy to buy the “whole market.” To make the task easier, let’s stick to the S&P 500 stock index, and consider three different ways to invest in the index -- each with different costs, liquidity, and leverage.
Index mutual fund
This is the easiest way to buy the “whole” market. Almost every 401(k) retirement plan has an S&P 500 index fund as one of its choices. And if you’re investing on your own, the major mutual funds, such as Vanguard and Fidelity, offer index funds on a no-load (no-commission) basis.
When buying or selling shares in a no-load index fund, your order will be executed at the day’s closing price. So if the market has a big rally, or falls late in the day, you can’t take advantage of earlier prices. For long-term investors, one day’s price fluctuation shouldn’t make much difference anyway.
Vanguard prides itself on very low annual costs. Its S&P 500 index fund subtracts just 18 basis points (one basis point is 1/100th of 1 percent) to cover operating costs. Since index funds don’t trade stocks, the funds have very low transaction costs. Only when new stocks are added to the index, or others are deleted, are there major changes. Otherwise, the fund managers simply purchase more shares of every company in the index as new dollars arrive from investors.
Buying an index fund is the easiest way to own “the market.” But there are other ways, too.
The one drawback to an index fund is that your order is executed at the end of the day. But what if you want to own the stock market right now? Many traders or market timers want to get in -- and out -- quickly. They don’t want to wait until the end of the day.
In recent years, exchange- traded funds (ETFs) have become a popular way to trade the “whole market.” Specifically, the “Spiders” are a “package” of the S&P 500 stocks. The S&P spider ETF is traded on the American Stock Exchange with the ticker symbol SPY, just like a stock.
These units are designed as a security with a market value of approximately one-tenth of the value of the underlying index. Thus, today with the S&P 500 trading around 1,140, SPY is trading at $114. So, 100 shares would cost $11,400. When buying on margin, investors put up 50 percent.
You pay a commission every time you buy or sell, just as with any other stock, but the advantage is that you can buy and sell throughout the day, acting on your instinct about where “the market” is going.
E-mini S&P 500
There’s another, more leveraged way to buy the “whole market.” It’s done by trading the E-mini S&P 500 futures contract. These contracts are traded on the Chicago Mercantile Exchange -- a publicly traded company where, full disclosure, I am a director.
The advantage of using a futures contract is that you can “control” a much larger position in the market for a relatively small amount of money. The current value of one E-mini S&P 500 contract is about $56,000. The margin requirement is $4,000 -- about 7 percent of the total value of the contract. (Investors would have to put up $28,000 to buy $56,000 worth of Spiders.) Of course, leverage works both ways. If the market declines, you can be called to put up more margin money!
The E-mini S&P 500 contract is traded electronically on Globex, and the market is open virtually around the clock. It has average daily trading volume of $38 billion, compared to the Spiders, which trade about $4.5 billion per day.
For more information on these three “buy the market” strategies, read the complete book on the subject, Exchange Traded Funds and E-mini Stock Index Futures by David Lerman (Wiley; $39.95).
Over the long run, the stock market has always been a good bet. But there are times you might want to trade, leverage, or hedge that bet. Now you know how to do it! That’s the Savage Truth.
Terry Savage is a registered investment adviser, and appears weekly on WMAQ-Channel 5’s 4:30 p.m. newscast. Distributed by Creators Syndicate.