Whenever we hear the stock market news, we hear about the Dow, the NASDAQ, and the S&P 500. Undoubtedly, investors rely on stock market indexes for guidance regarding the state of the broader market. For many years, investors had one index to follow. The Dow Jones Industrial Average was the only game in town for a long time. But the Dow had some limitations that institutional investors found difficult to overlook.
As a result of these limitations, many other stock indexes have been created. And perhaps no index is more highly regarded than the S&P 500. This article focuses on what the S&P 500 Index is, how it is different from other indexes, primarily the Dow, and what are the features of the S&P 500 Index that makes it the “go-to” index for many institutional investors.
What is the S&P 500 Index?
The Standard and Poor’s (S&P) 500 index is a widely used stock market index that follows the stock price performance of 500 large cap companies. Large-cap companies have a market capitalization of over $10 billion. Because it tracks the performance (good and bad) of the largest companies, the S&P 500 index is widely regarded as a reliable indicator of the overall stock market's performance. In the last decade, the index has had an annual return of 9.49%. In 2017, the S&P had a return of 21.83%.
How are the companies in the S&P 500 selected?
The companies that make up the S&P 500 index are selected by a select group of market professionals known as the Index Committee. Like other major indices, the objective of the S&P 500 is not to beat the market but to provide an accurate picture of what is going on in the market. The index is exclusively focused on large-cap stocks, those with a market capitalization of over $10 billion. The committee also considers other factors including liquidity, minimum float, profitability and their balance in relation to the overall market to help ensure the S&P 500 provides an accurate view of the overall market. The committee rebalances the index every quarter (March, June, September, and December).
To be considered for inclusion in the index, companies must meet certain selection criteria including:
- They must have a minimum market capitalization (currently about $6.1 billion)
- They must have a public float of at least 50%. This means that at least 50% of a company’s stock is available to the public and it has a stock price of at least $1 per share.
- They must file a 10-K annual report
- At least 50% of their fixed assets and revenues must be in the United States
- They must have reported positive earnings for the most recent four quarters
- They must have adequate liquidity as measured by price and volume
The combined market cap of all the companies in the S&P 500 index totals over $23.5 trillion. This number represents 80 percent of the market capitalization of the entire stock market. And because the S&P 500 index covers all major sectors of U.S. companies, it is generally considered to be the benchmark that most equity managers are measured against. Although every company in the S&P 500 is headquartered in the United States, the companies are international companies with revenue coming in from all over the world. This adds to the diversification of the index.
However, unlike other stock indexes that base their selection of composite companies exclusively on a defined set of rules, the S&P index is actively managed, meaning that the committee has some discretion in the stocks they select. This allows the committee to respond, as needed, to market events.
What is the methodology for weighting the stocks in the S&P 500 index?
The S&P 500 index is weighted according to their market value. The adjusted market capitalization of every stock index is added together and divided using a proprietary divisor. Like the Dow divisor, the divisor is adjusted for stock splits, special dividend issues, or spinoffs and mergers that can affect the value of the index. This means that if a $20 stock experiences a 10% change and a stock that trades at $50 also experiences a 10% change, the index will be affected the same way.
The formula is as follows:
Index = SUM (market cap of all S&P 500 stocks)/Proprietary Divisor
Although this methodology allows the index to respond proportionately to changes in stock prices no matter what a company’s market cap is, the methodology does mean that the index is weighted towards companies that have a large market cap.
For example, the largest company by market cap in the index is Apple. Their market cap is $1.09 trillion. In the middle of the pack is Royal Caribbean Cruises Ltd. Their market cap is $26.15 billion. Both of these stocks are divided by the same number, which is the total market capitalization of all the stocks in the S&P 500 (currently around $23.5 trillion). The formula looks like this:
Apple: 1.09 trillion (their individual market cap)/23.5 trillion (the sum of all the market caps in the index) = 4.433%
Royal Caribbean: 26.15 billion/23.5 trillion = 0.085%
So looking just at this example, you can see how the largest of the large-cap stocks can have a significant impact on the overall index.
How diverse is the S&P 500 index?
While it's true that the S&P 500 index is weighted toward the largest of the large-cap companies, the scope of companies allows it to showcase diversity over many reliable metrics.
S&P 500 Revenue by Country - As of December 31, 2017, over 70% of the revenue earned by S&P 500 companies is generated in the United States. In fact, the revenue earned in the United States has increased by nearly 3%, since March 2016. A distant second in terms of revenue generation is China at 4.3%. Japan (2.6%) and the United Kingdom (2.5%) were third and fourth respectively.
S&P 500 Revenue by Region – Largely on the strength of its revenue from the United States, over 75% of the total S&P 500 revenue came from the Americas. This compares to 73.6% in 2015. The Asia-Pacific region comes in second at 11.1%. In recent years it overtook Europe which accounts for 10.6%, followed by the Africa/Middle East region that accounts for 2.4% of revenue.
S&P 500 Revenue by Sector – As of 2017, the sector breakdown of the S&P 500 was:
Information technology – 24.9%
Financials – 14.7%
Health Care – 13.7%
Consumer Discretionary – 12.7%
Industrials – 10.2%
Consumer Staples – 7.7%
Energy – 5.7%
Utilities – 2.9%
Materials – 2.9%
Real Estate – 2.8%
Telecom Services – 1.9%
Is the S&P 500 index publicly traded?
Like the DJIA, the S&P 500 (SPX) is not an index fund in and of itself. But there are many index funds that use the stocks inside the S&P 500 as their benchmark. Some of the most popular funds are:
- Vanguard 500 Index Fund Investor Shares– The objective of this fund is to provide results that correspond to the price and yield performance of the S&P 500 index. The fund uses an indexing strategy that weights the stocks in approximately the same proportions as the SPX. Since its inception in 1976, it has generated an average annual return of over 11%.
- Schwab S&P 500 Index Fund – The objective of this fund is to provide results based on the total return of the SPX. Approximately 80% of the total net assets are in stocks that are part of the SPX and weights them in approximately the same proportions.
- Fidelity Spartan 500 Index Investor Shares– This fund is considered an alternative to the Vanguard and Schwab funds and since its inception has had a 10.2% average annual return as well as a uniquely perfect positive correlation to the SPX. Like the Schwab fund, approximately 80% of the fund’s total net assets are in stocks that comprise the SPX.
- Rowe Price Equity Index 500 Fund– this fund was launched in 1990 and has delivered an average annual return of 9.5%
How is the S&P 500 index different from the DJIA?
There are several key differences between the S&P 500 and the Dow Jones Industrial Average (DJIA). Perhaps the most notable distinction is that the S&P 500 is weighted by market cap whereas the DJIA is weighted by stock price. While both indices use a divisor to smooth out events such as stock splits and dividend issues, the S&P’s weighting based on market capitalization is one reason why institutional investors view it as a more reliable index for assessing market trends.
Critics of the Dow have rightly noted that a company with a large market cap could issue a stock split, cutting their stock price in half. This would have a disproportionate effect on the Dow, whereas the S&P 500, because it looks only at the market capitalization would be less affected.
Second, the S&P 500 is comprised of 500 stocks representing a variety of sectors of the U.S. economy. The DJIA is composed of 30 components (companies) making it much less diverse. A third distinction comes in the way the indices are managed. Although the components of the DJIA do change from time to time, the changes are fairly rare and although the companies may change the index largely follows a formula.
By contrast, the S&P 500 index is considered to be actively managed. The S&P 500 index defends its position by pointing out that the market, on occasion does not play by the rules. For example, at the height of the financial crisis, the collapse of Lehman Brothers threw the market in chaos. One of the casualties was the insurance giant, AIG who was bailed out by the U.S. Treasury who subsequently owned over 90% of the company. Per the S&P 500 guidelines, a company must have a public float of over 50% which would have meant that the company would have to be removed from the index. However, understanding the effect that AIG's removal would have on the broader market, the committee set aside the 50% requirement without fanfare. In just a few years, the Treasury sold its shares back to AIG and put the company within the 50% float threshold.
A second example, on a smaller scale, took place when Google issued a stock split and issued non-voting stock, the committee recognized that some of the rules would have to be revised and then revised them again in response to major investors who expressed concerns based on the heavy volume of trading that would be required until the schedule was published.
Of course, any time human judgment is brought into an index, there is an opportunity for human error, but when put into context; the changes that are made to the S&P 500 are not being made to artificially inflate the price of an individual component stock, but rather to accurately reflect what those changes really mean.
How is the S&P 500 index different from the Russell Index?
There are two key differences between how the two indices are constructed. First, the S&P 500 uses a committed to select the stocks that make up the index. The Russell index uses a formula that chooses the stocks that are included. And second, the S&P 500 does not include the same company in a different style of indices. This means that a company that appears in their growth index would not be listed in their value index. The Russell index does not make these distinctions.
The bottom line on the S&P 500 index
The S&P 500 Index (SPX) is widely regarded among institutional investors as a leading indicator for tracking changes in the economy. It is also a recognized way for investors to get exposure to a broad cross-section of the U.S. economy. The index was created in 1957 and ever since has shown to consistently outperform other asset classes.
Although often referenced in tandem with the Dow Jones Industrial Index (DJIA), the S&P uses a different methodology than the DJIA. By weighting the component stocks by their market capitalization rather than their stock price, no component of the SPX will disproportionately affect the overall index. The market capitalization-weighting structure is more common than the price-weighted method across U.S. indexes.
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Who knew that something so tiny could create such a big problem? However, that’s the case with the semiconductor industry. Chip manufacturers are facing supply chain disruptions due to the Covid-19 pandemic.
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