Flaws With the S&P 1500 ETF And Why I'm Not Buying

At first blush, an exchange traded fund that tracks the performance of 1500 US-based companies seems like the perfect, broad-based investment vehicle for a fan of ETFs like me. But on closer examination, I find it quite lacking.

Make Up of the S&P 1500
The S&P Super Composite, consists of the 1500 companies that comprise the S&P 500, the S&P mid-cap 400 and the S&P small-cap 600. All of the indexes that Standard & Poor's constructs are considered to be managed indexes because the added companies must pass several screens before they can be added to the index family.

Standard and Poor's starts with a universe of 10,000 companies which is screened to eliminate Real Estate Investment Trusts, companies that IPOed within the last 6 months, (12 months for the 500) and foreign companies. Instead of adjusting for free float, Standard & Poor's requires that at least 0.3% of the shares outstanding turnover each month, and that insider/cross ownership must be less than 50% for one entity, 60% for multiple entities. In addition, to be eligible, a company must have four quarters of positive net income on an operating basis to be added and must be consistent with the goal of matching the sector weights of the Standard & Poor's Stock Guide Database. Companies are added whenever one is removed, which usually occurs as a result of merger activity, although bankruptcy and illiquidity are also reasons for removal.

Flaws
I'll admit that the word flaw is harsh. Technically, the S&P 1500 does exactly what it is designed to do. My issue with it is that it really doesn't provide diversification in to companies of different market capitalization. This is because the index is weighted by market capitalization meaning that the S&P 1500 ends up having 91.2% of its value tied to large companies. Only 1.8% is tied to small companies.

This isn't much different than just buying in to an S&P 500 ETF. But if your goal is capture the movement of different sized companies, you need to split your investment dollars in to the three constituent parts of the S&P 1500. For those that are even more aggressive, you might want to look in to a micro-cap ETF as well.