How to invest in the U.S. market without using ETFs
Many investors want to add stocks of major U.S. companies to their portfolios.
Warren Buffett openly declares that it is necessary to bet on the American market: “Nothing in principle can stop America.
There are three main stock indices traded on U.S. exchanges: the Dow Jones, the Nasdaq and the S&P 500. They act as benchmarks, i.e. samples, and, to varying degrees, reflect the state of the U.S. economy. Investors most often focus on the S&P 500, as it is represented by a much wider range of companies and industries.
Before we look at these indices in more detail, I will outline the idea of this article: we are looking for a strategy that would allow us to invest in the U.S. market on our own, without resorting to the use of exchange-traded funds.
Disadvantages of investing in ETFs
Investing through an ETF may not suit an investor for the following reasons.
The fees charged by the fund for asset management. For example, Its annual fee is 0.9% of asset value. At the strategic distance, this can have a noticeable effect on the portfolio’s bottom line.
It is impossible to exclude substandard companies. The ETF offers a broad set of stocks that, in addition to the top companies, include fundamentally weak companies or those in which the investor does not want to invest for some reason: it may be personal brand aversion or ethical considerations. For example, someone on principle does not want to support the tobacco business or military companies, and they are often represented in indices: Altria, known for its Marlboro cigarette brand, and U.S. defense companies Lockheed Martin, Raytheon are represented in the S&P 500, S&P 100 and Russell 1000 indices.
It is impossible to fine-tune such a portfolio. An investor may need to reduce a stake in one company and build up a position in another. They may also need to buy a quality company that is not in the S&P 500. In all of these cases, the portfolio will have to be balanced by buying individual stocks, something the investor had hoped to get away from by relying on ETFs.
Not all ETFs pay dividends, especially those represented on the Moscow Exchange. FXUS, in particular, does not: the dividends received are reinvested within the fund. At the same time it is registered in Ireland and pays 15% tax on dividends. At the same time, if the Russian investor who signed form W-8BEN, receives dividends independently, the total withheld personal income tax on dividends is 13%. And he can dispose of the payments he receives at his discretion.
Lack of drive. Investing through ETFs saves time: the investor has little or no need to manage a portfolio. But many people are interested in taking an active position in investing: regulating the process, researching and selecting companies – for many it becomes a kind of profitable hobby.
The desire to build a portfolio on your own is justified. All we need to do is choose a strategy. If the goal is the U.S. market, we can focus on one of the indices, as well as the corresponding ETFs. By copying the list of the fund’s assets in the right proportions, we get a portfolio that is as close to the benchmark as possible.
The difference between Dow Jones, Nasdaq and S&P 500
The Dow Jones Index. The oldest of the three indices, it is over 100 years old: the first versions of the index appeared in 1884, and in 1896 it was introduced as an “industrial” index because its purpose was to track the development of the industrial component of the US economy.
The index tracks 30 giant companies listed on the New York Stock Exchange (NYSE) and Nasdaq. Today, the index represents various areas of the economy: communications, oil and gas, technology, pharmaceuticals and entertainment, so the characteristic “industrial” remains only formally – as a tribute to the past.
One of the main drawbacks of the index is the way it is calculated: the prices of its constituent shares are added up and then divided by a correction factor. As a result, a smaller-capitalization company with a higher price per share affects the index more.
The second significant disadvantage – the index covers only 30 companies, so it is poorly suited for the role of a benchmark, by which you can track the overall state of the market. So, for objectivity, the S&P 500 is often used along with the Dow Jones index.
The SPDR Dow Jones Industrial Average (DIA) ETF allows you to invest in the Dow Jones Index.
S&P 500. The index was created by Standard & Poor’s in 1957 to track the 500 largest companies traded on the NYSE and Nasdaq. Unlike the price-weighted Dow Jones, this index distributes the weight of companies according to market capitalization: the larger the company, the greater its share.
The S&P 500 accounts for 80% of the U.S. stock market capitalization, so it serves as an indicator of the state of the economy. The index is diversified across various sectors, with technology accounting for the largest share – about 26%.
Nasdaq 100. Consists of the 100 largest U.S. and international non-financial companies listed on the Nasdaq exchange. The index appeared in 1985 and is weighted by capitalization. Unlike previous indices, the Nasdaq 100 is high-tech: half of its weight is occupied by IT companies.
Behavior of indices
Investing in each of the three indices embodies a different strategy, and the historical data confirm this. Let’s evaluate the indices’ performance over a 15-year period, since January 2005.
Comparison of index indicators for 15 years
| Index | Average annual | Best year | Worst Year | Max drawdown | Volatility |
| Nasdaq 100 | 13,86% | 54,68% | −41,73% | −49,74% | 17,59% |
| S&P 500 | 8,68% | 32,18% | −37,02% | −50,97% | 14,55% |
| Dow Jones | 8,49% | 29,64% | −32,16% | −47,05% | 13,96% |
The Dow Jones is less volatile because it includes only blue-chip, large-cap companies. At the same time, other indices have a share of mid-cap companies in their portfolios. The Nasdaq 100 also has higher volatility because of its focus on fast-growing technology companies.
The charts below show that the Dow Jones and S&P 500 are moving in tandem, while the Nasdaq 100 is fluctuating differently. This is because in the last business cycle, the IT sector grew the strongest, and the shares of the FAANGM mega-corporations (Facebook, Amazon, Apple, Netflix, Google, Microsoft) rose several times. Their share is 48% in the Nasdaq 100 and only 22% in the S&P 500. Due to this, the performance gap between the indices has increased.
If we look further back, we saw a similar picture in 1999-2000, during the dot-com boom. Tech stocks rushed upward, pushing the Nasdaq 100 up 130% and the S&P 500 with Dow Jones up about 11%. In March 2000, the dot-com bubble burst: The Nasdaq 100 sank 67% and the S&P 500 sank 23%. The Dow Jones Index was the least volatile during this period, losing 13%.
You can see how the Nasdaq 100 rose and fell during the dot-com boom of 1999-2000 and how it is rising now. Source: Capital.com
Let us summarize the results:
- It is easy to build a portfolio that copies the Dow Jones index – all you have to do is buy shares of 30 companies. Such a portfolio is stable and has the least volatility. It has a good sector breakdown, but its main disadvantage is that it is weighted by price, not capitalization.
- The Nasdaq 100 emphasizes technology companies and offers the highest returns. Copying the 100 companies of the index will create a technology portfolio relevant to the new techno-economy. At the same time, it is worth noting the increased volatility, as well as the weak structure – a clear skew towards one sector.
- The S&P 500 best represents the U.S. economy and is diversified by company and sector. Some of them, such as the commodities and oil and gas sectors, which have performed poorly in the last decade, retain growth potential in the event of a new commodity cycle or rising inflation.
Independent investing in the S&P 500
When an investor has enough time and will to manage his portfolio, copying an index and not paying commissions to funds is a great idea. And by excluding a number of undesirable and unprofitable companies from the list, you can even outperform the benchmark.
With such indices as the Dow Jones (30 companies) or the Russian MICEX (45 positions), or even the Nasdaq 100, there is no problem: an ordinary investor can put together such a portfolio and manage it. But what about the S&P 500? The idea to follow 500 companies looks utopian. Even to buy all positions in the necessary proportions, it can take several months.
Since the S&P 500 is weighted by capitalization, meaning that a company’s share of the portfolio depends on its size, the top 50 companies in the index account for more than half of its weight. And the companies at the end of the list occupy hundredths of a percent and because of that have little or no impact on it. Accordingly, if we exclude them from the portfolio, we will still have a high correlation with the index.
To begin with, let’s narrow down the number of companies in question to 100, to be like the Nasdaq. There is a corresponding index – the S&P 100. It is replicated by the iShares S&P 100 ETF (OEF).
Let’s compare the S&P 500 and S&P 100 at the same historical distance of 15 years if we had invested $10,000 in each. Calculations exclude inflation and dividends.
Comparison of index indicators for 15 years
| Index | Bottom line | Average annual | Max drawdown | Correlation with the US market | Annual average volatility |
| S&P 500 | 36 880 $ | 8,74% | −50,80% | 1 | 14,53% |
| S&P 100 | 36 197 $ | 8,61% | −50,13% | 0,98 | 14,07% |
The S&P 500 brought in $683 more, outperforming the S&P 100 annually by an average of 0.13%. But the latter’s maximum drawdown and volatility is lower. This is because 13% of the weight of the S&P 500 is in mid-cap companies, while there are none at all in the top 100 of the index – only the giants are there. This gives us additional stability, but less growth potential.
The sector division of the S&P 100 has expectedly shifted toward the technology sector, with 33.4%, but the Nasdaq’s inherent focus on technology is still a long way off.
Sector division of the S&P 100 and S&P 500
| Sectors | Share in S&P 100, % | Share in S&P 500, % |
| IT | 33,36 | 27,48 |
| Communication Services | 14,80 | 11,01 |
| Health Care | 13,01 | 14,13 |
| Consumer Discretionary | 12,60 | 11,44 |
| Financials | 8,30 | 9,93 |
| Consumer Staples | 7,59 | 7,12 |
| Industrials | 5,14 | 8,34 |
| Energy | 2,24 | 2,22 |
| Utilities | 1,46 | 2,95 |
| Real Estate | 0,67 | 2,69 |
| Materials | 0,39 | 2,69 |
Further narrowing of the S&P 100
An investor who does not have time to deal with a list of 100 companies may find it sufficient to reduce the list to 50 – or even take a smaller number. But it is worth understanding that sector coverage and diversification will decrease as the number of issuers decreases, while the focus on technology and portfolio volatility will increase.
To track the top 50 companies in the S&P 500, we will use the Invesco S&P 500 Top 50 ETF (XLG). Also for clarity, let’s take the top 10 stocks in the index and make a portfolio of them, weighted by capitalization. Facebook stock only entered the market in 2012, so the period under consideration is narrowed: let’s track the behavior of portfolios from January 2013 with an investment of $10,000.
Comparison of indexes for 7 years
| Index | Bottom line | Average annual | Max drawdown | Correlation with the US market | Annual average volatility |
| S&P 10 | 74 570 $ | 30,34% | −18,46% | 0,8 | 16,61% |
| Nasdaq 100 | 44 108 $ | 21,62% | −16,96% | 0,9 | 15,06% |
| S&P 50 | 28 483 $ | 14,8% | −16,86% | 0,97 | 13,07% |
| S&P 500 | 27 088 $ | 14,04% | −17,59% | 0,98 | 12,94% |
The S&P 50 is still closely correlated with the S&P 100 and S&P 500, showing roughly the same result. The IT sector’s share of it rose to 38.15% and its volatility rose to 13.07%.
As for the list of the top 10 stocks, IT’s share of 43.1% is still less than the Nasdaq. We see the S&P 10 growing twice as well as the S&P 50 and S&P 100, and it is also well ahead of the Nasdaq 100. But it has the weakest market coverage and the most volatility.
Betting on the top 10 companies fully justifies itself when we are talking about the growing part of the portfolio, but it cannot act as a full-fledged investment strategy because of poor diversification. Especially if we face a situation similar to 1999-2000 in the IT sector. I recommend compiling the portfolio in such a way that no single security has a share of more than 5% of the total size, taking into account the presence of additional instruments in the portfolio that hedge equity risks – for example, gold.
Sector division of the S&P 50 and S&P 500
| Sectors | Share in S&P 50, % | Share in S&P 500, % |
| IT | 38,15 | 27,48 |
| Communication Services | 17,10 | 11,01 |
| Health Care | 14,48 | 14,13 |
| Consumer Discretionary | 11,96 | 11,44 |
| Financials | 6,57 | 9,93 |
| Consumer Staples | 7,56 | 7,12 |
| Industrials | 0,81 | 8,34 |
| Energy | 2,53 | 2,22 |
| Utilities | 0,84 | 2,95 |
| Real Estate | 0 | 2,69 |
| Materials | 0 | 2,69 |
Remember
- When forming a portfolio independently, without using ETFs, the Nasdaq 100, Dow Jones and S&P 500 indices can serve as a model.
- Copying the Nasdaq 100 will build a high-yield and technology portfolio, but with increased volatility.
- The Dow Jones has low volatility, but the index is weighted by price rather than capitalization and includes only 30 companies.
- The S&P 500 offers the best sectoral coverage and broad diversification. That is why it usually serves as the benchmark.
- The S&P 500 assumes management of a large number of companies. For independent portfolio construction, it is better to use the S&P 100 and S&P 50, which are tightly correlated with the main benchmark.
- As the number of companies decreases, the focus on technology and portfolio returns increases, and with it, so does its volatility. The top 10 companies on the S&P 500 list at historical distance deliver the highest returns of all the indices reviewed, but for an investment portfolio, they offer too little coverage and diversification.
