We sometimes hear concern about how top weighted the S&P is, with 20% of its value in the top 5 out of 500 stocks. This actually makes sense, and is not a misrepresentation.
The S&P 500 has been around for 63 years now, and a lot of people have invested in it and continue to do so today, so it’s pretty amazing that so few really understand it as well as they should. On the other hand, not a lot of investors really look into what they are investing in very deeply, and think this is an average of 500 stocks. It’s actually not quite what you may think.
The part about it having 500 different stocks is easy enough to spot, but if we think that having it top heavy is somehow misrepresenting things, we don’t really understand it very well. This is the way it is designed to be, where big stocks are worth more to the index than dozens of them together, and it is to our benefit ultimately that it is set up in such a fashion.
Many also think that this index represents the “market,” thinking that it is not just an average of stock prices but an average of all stock prices in the stock market, and this takes us even further from the truth. The S&P 500 is an average of sorts, but of a different sort than many realize.
The first thing to know about this index is that it uses what is called capitalization weighting, or cap weighting, which means that within a given number of stocks tracked, one share is one vote. If we put 10 stocks in a cap weighted index, and one of them had 9 billion shares, and the other 9 had only a billion combined, the big stock would represent 90% of the index, of the “market.”
This is therefore not just a matter of taking the price of these stocks and averaging them out in any sense. The bottom 9 in our example could double in price and the top stock could lose half its value, and if this were an average, we’d be up 85%. With a cap weighting, we’re down by 35%.
There’s also the matter of how many shares of a company that we’ll be counting when we do this weighting, whether this capitalization weighting is fixed, counting all of the shares out there with each, or free-float weighted, counting only those shares that are held by the general public, and excluding those owned by governments or those in the company.
It is the shares held by the company that make the real difference here, although the concept of free-floating originated in countries where their governments held a significant portion of stocks. These stocks, and the ones that are held by insiders in companies, are not really in play, so it is believed that by excluding them, we’ll get a better idea of how the shares that matter are moving, the ones that are in what we call the float.
This concept is easily understood if we look at an initial public offering, or IPO, where a company will float a certain percentage of their shares by offering them for sale on a public exchange. These shares become traded, and this results in their changing value over time, but the ones held back are not in play and if we want to understand what is going on with shares traded publicly, it makes more sense to actually just count the ones that trade publicly, the float.
The reason why this all matters is that it tells us that we cannot just look at a company’s market capitalization, the total number of shares outstanding times the current price, to get a good idea of a certain stock’s contribution or influence to an index. This also can be used to better compare individual stocks, even though this is not something individual investors would do, and there are other ways to get an idea of this than looking at floats, but looking at this can provide some additional insight at times with regard to the potential for volatility that a stock may have.
You can’t just get this from looking at a stock’s float though as that doesn’t really tell us much. The percentage of the float that is traded is a different matter, and the higher the percentage, the more potential for volatility it has. We, of course, can just measure volatility by looking at price, but that is always focused upon the past and using traded percentages.
This is a little esoteric for investors, more than a little in fact, but if we want to understand why a certain stock has a certain weighting, we need to at least understand how this is calculated.
The bigger of these two factors by far is the fact that the weightings are according to market cap, and this does not just mean that we need to treat these stocks differently, although we certainly do. For example, if you hear that the Department of Justice is hunting down stocks like Amazon, Apple, Microsoft, Facebook, and Google, and the threat this time is real, we’re talking about 20% of the value of your S&P 500 index shares right there, and you therefore really need to pay attention as this is not 5 out of 500.
You therefore need to pay a lot more attention to these than, say, the bottom 350 stocks that are worth less than the top 5. If our attention to stocks in our index is not proportional, we just won’t know what is going on and will be more prone to mistakes.
This process is not static, like for instance stocks given a certain weighting which they keep, as market capitalization changes each day and these stocks just weren’t selected to be in the top 5, they got there from growing so much. The more they grow, the bigger their share of the index becomes, and the more they grow the index.
This might sound strange and maybe even a little scary, like a blob from a cheap horror movie growing and growing, but all of this not only makes sense, it is beneficial and needed.
When you buy a share in an index, it will contain all the stocks in it, in appropriate amounts, properly weighted we could say. If we tried to give them all the same weighting, this could not even be maintained, as each time the price changed with any stock, our holdings would need to be rebalanced.
Cap Weighted Index Funds Rebalance Automatically, and Rebalance for Performance
A lot of people are familiar with the concept of rebalancing their own portfolios, often between stocks and bonds but often between different types of stocks. The price of something goes up, and we now have to sell off a portion of that stock and spread it among the rest to achieve an even distribution now.
This is like selling stocks when the go up in value more than your bonds, to keep a certain ratio such as 60/40, and while that may not be a wise approach, it’s a popular one. You might do this a few times a year but you couldn’t do it continually, and in between you become unbalanced to a certain degree.
You can’t have stock indexes unbalanced though, and you can’t continually adjust them either as each time you adjust, something needs to be bought and sold, like our selling some of our stocks to buy more bonds. We can just keep the same proportion though and allow the proportion that stocks contribute to an index to float, according to their changing prices.
We need to realize that index funds are bought and sold continually, and you can’t have someone else’s basket different than yours. If someone buys the index yesterday, and prices change, you bought the index itself, not so many shares of each stock, and the distribution of the thing will have changed.
The basket itself therefore needs to adapt to changes, and you can’t do this by just assigning one share one company proportionality. We need weighting of each stock to adapt, and market cap weighting accomplishes this by changing the percentage of the index that a stock has dynamically.
All of these big stocks were at one time bit players in the index, but as their prices rose faster than the index, they grew in significance. They grew a lot in significance in the market as well, so it only stands to reason that they should hold a bigger share of indexes as well.
This actually turns out to be to the benefit of index investors by allowing those stocks that are doing well to have them play a bigger role, where those which aren’t doing so well are afforded a lesser significance. You want more Amazon generally if you want better performance out of your index, and less of the junkier stocks, given the choice, and the way indexes are weighted these days makes this happen.
The S&P 500 is therefore structured for performance on the bullish side, not by accident but by design. This is no average, it is instead a dynamic structure that is set to bend more upward than the average stock by allowing outperformers to increase their weighting and underperformers to see their weightings reduced.
For investors, particularly those who do not even have any interest in making any decisions beyond just buying and holding the index fund, this structure both allows them to hold a bigger proportion of good stocks than average, it also allows them to leverage this advantage as it manifests, adding a steady supply of hormones to our bull to make him grow larger than otherwise.
A momentum strategy is therefore built into this index, because we’re basically weighting by momentum. The effect isn’t quite like you get when you do this with momentum stocks, as the laggards with broader inclusions like the S&P 500 has do drag down returns, but do so in a dissipating fashion at least which does remove some of the bad performance on the downside and repurposes it with more upside.
People who like value stocks really won’t be pleased to learn this, although that sort does tend to go off on its own and choose funds that specialize in these poorer performing stocks. Still though, a lot of index investors are under the impression that the S&P 500 is balanced toward value, which would be the case if not for it being weighted to favor momentum, where the stocks that have higher ratios being more represented than those with lower ratios.
This is why the S&P 500 regularly beats the pants off of value funds, because they are biased toward the other end of this spectrum. This is also a big reason why beating the S&P 500 is more challenging than it would be if this were just the averages that people think that they are.
The S&P 500 is Considerably Better than Average Stocks, Including Their Average
If all you were against is a randomly behaving set of stocks, anything above the average would beat the market. It’s a lot harder to do if your opponent is weighted toward being more in the good stocks than not. This actually happens by way of the beauty of mathematics rather than a process subject to human failings in judgement, and there’s lots of that going around.
This is not to say that the way indexes weigh stocks is any sort of ideal, as we could skew ours even more toward momentum, and we have lots of funds that at least try to do this. If we choose well, like the good momentum funds do, we will be rewarded with better performance than the index, but we can really mess this up as well, for instance by holding on to stocks that have turned from worthy to less so if it is managed actively, with people changing the horses in it.
Index funds eliminate these mistakes while still pursuing similar goals, by way of their natural inclination towards weighing better performance more and lesser performance less.
Index weighting ramps up the value of a stock as it goes up, and ramps it down as it declines, where fund managers who have to manage which stocks are in their basket have to make their adjustments in periods of significant duration. In our previous example, the stock that was 90% of the value of our 10 stock index doubles, with the rest not changing, and it is now 95% of the value of the index. This balancing act is automatic, where our fund managers have to do so periodically, and will generally look to balance things the other way, selling some of the good stuff and placing the funds in lesser performers.
The S&P 500 is therefore more than it appears to be, and is to some degree a well-oiled bull machine designed to grow faster than the actual market, if that means the average of all stocks. You can actually beat the market by investing in what a lot of people call the market, and who knew?
You can actually invest in an equal weight version of the S&P 500, and we can see the difference between these just by measuring their relative performance. The equal weighted version has a 5-year trailing return of 16%, while the actual index, the cap weighted version, is up twice as much over this time, 32%. This is clearly a good thing if you bet on the bull side as all investors do, and really shows that we’re taking on a more potent strategy than just how the average stock moves.
When you take a market like the Nasdaq, which has a bigger helping of good stocks and a smaller helping of the lesser stuff, this effect increases, and by quite a bit in fact. Now, we have an index that is assembled with view more toward performance rather than toward a broader representation, and while some active funds beat the S&P 500, the Nasdaq is a much stronger opponent and they all bow to it over time.
Indexes therefore are not such a docile and neutral beast as we think, and while there are some that are skilled enough to actually beat the Nasdaq, very few investors are, and the fact that it is actually a harder task than people think has a lot to do with this.
There are indexes even more focused toward performance than the Nasdaq though, with the technology SPDR that we recently featured being one example. This selects the best performing of 11 sectors in the S&P 500 and works its weighting magic with that instead. With the fast horses designed to lead the way, and with your having faster horses overall, this is really the way to get the pack running.
There is therefore a lot more to the story of 5 stocks representing 20% of the value of the S&P 500 than the usual fare of thinking that this makes the index more overvalued. That part is actually true, but overvalued here means more prone to growth, and that’s a good thing not a bad thing, if you like to make money from investing in this stuff that is.