Index investing is the rage now. Many people swear by it, and vow never to touch any other type of investment in the stock market.
But I discovered a nasty little secret: Every index is made up of individual stocks!
Yessir! Behind every index investment is a list of individual stocks.
How The Index Is Created
The S&P 500 index, which is the most popular index for investing these days, is made up of common stocks of the largest 500 or so companies in the U.S. As a matter of fact, a few of these companies have more than one class of stock issued, so the current index is made up of 505 common stocks from 500 companies.
According to Wikipedia , “The index is weighted by free-float market capitalization, so more valuable companies account for relatively more of the index.”
So the S&P 500 index is not made up of the same number of shares from each company. The index is created as follows.
1. For each company, determine the number of outstanding shares that are available to be traded. If the company has shares that are in the company treasury and not traded, or are otherwise restricted, these are not counted.
2. Multiply the number of outstanding shares by the current price. This number is the market capitalization (market cap).
3. Add up the market capitalization for all the companies, divide by an index divisor. The result is the S&P 500 index.
Purchasing an index fund or ETF that follows the S&P 500 means that the managers of the funds buy and sell shares in the proportion which they are in the index each day. When share prices increase, purchasing additional shares is the definition of increasing demand. Because the index is weighted by current market cap, the fund purchases more shares of the companies with larger market cap. This further increases the prices of the larger constituents of the index.
The net result is that the index increases.
What It Means
It means that price increases of some companies moves the index much more that other companies. The companies with larger market cap have an outsized influence on the index.
It also means that price declines for a large cap company will move the index down in an outsized way.
Other cautions
The S&P 500 is made up mostly large cap stocks. This means that the state of mid-cap and small cap equities are not part of the index.
It has been suggested a more equitable index would be an equal-weight index, where the same number of shares from each company would constitute the index. The reasoning behind this idea is that although the S&P 500 is made up of (approximately) 500 companies, because of its market capitalization structure, there are times that just 50 companies can comprise around 50% of the index. There are times that one high-flying stock can comprise over 3% of the index. Many see this as a distorted measure of stock market activity.
Other Approaches
Even some funds and ETFs that are made of “total stock market” constituents are composed of a unbalanced mix of equities. A simple and popular example is the Vanguard Total Stock Market ETF (VTI). As of this writing, its 10 largest holdings comprise 31% of its holdings. All of the 10 largest are large cap stocks. So while this ETF contains large, mid, and small cap stocks, it is overweighted in large caps.
What about an Equal-Weighted Index
Actually there are such things. One example is the S&P 500 Equal Weight Index. Click the link for more information on that index.
The Wilshire 5000 here and here is considered by many to be the best index of complete U.S. stock market activity, it contains almost all public companies from small to large cap. While it originally had stocks for approximately 5000 companies, despite the name 5000, it currently has less than 3500 equities. There Wilshire 5000 index is available as a cap weighted index, or as an equal weighted index.
In a study of the Wilshire 5000, the Wilshire 5000 market capitalization weighted index returned a 10.5% annualized return from 1970-2016, each $1 invested would have turned in $102. However, using the Wilshire 5000 equal weight version of the index, your annualized return would have been 17.1%, each $1 invested would have returned $1,458 during the same period. You can read more about this analysis here .
Caveats
Equal weighted indexes are more volatile, and have a higher turnover which can lead to higher taxes and higher transaction costs.
The Bottom Line
The main point to consider is that index investing, like all investing, is fraught with possible distortions and anomalies. Index investing does not, in and of itself, remove potential distortions. Understanding the underlying components and proportions of whatever index any fund or ETF is based on can help an investor understand what they are investing in.
Disclosure. I do not own any of the funds or ETFs mentioned.
What do you think? Is index investing something you prefer? Have you investigated the index itself you are investing in? See Contact page how to send feedback.
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