Decoding the poetry of the S&P 500

November 13, 2019

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Martin Kleppe

Martin Kleppe

"The worst tragedy for a poet is to be admired through being misunderstood."
—Jean Cocteau

If the Standard & Poor's 500 Index were a poet, chances are it would blush—if not take offense—at how some people interpret it.

A vast improvement on the Dow Jones Industrial Average—created in 1896 as a price-weighted basket of what's today 30 stocks—the S&P 500 debuted in 1957 to act as a broader barometer of market performance relative to the DJIA.

Since then, the S&P 500 has become the most tracked index on the planet—but not necessarily the best understood.

With that in mind, it's important to clarify what the index is and what it is not. Only then can investors determine if it belongs in their portfolio—a decision that is often taken for granted.

Representation, not replication

Let's start with what the S&P 500 Index actually measures.

While the index seeks to include constituent companies that represent the sectors of the broad market, the S&P 500 doesn't own the entire U.S. stock market.

The index includes 505 stocks as of April 30, 2019, representing 83% ($24.5 trillion) of the total U.S. market capitalization. This compares with 3,748 stocks, representing 100% ($29.5 trillion), for the S&P Total Market Index—a difference of $5 trillion and 3,243 stocks.

S&P index methodology comparison

S&P index methodology comparison

Sources: Vanguard, Standard & Poor's, and FactSet. All data as of May 31, 2019, unless otherwise noted.
¹ This depiction of the S&P 500 and S&P Completion Indexes is illustrative with regard to the "gaps" in the index. As of April 30, 2019.

Investors trying to replicate the entire U.S. market should be aware that doing so with the S&P 500 exposes their portfolio to certain misweights relative to a more comprehensive, total-market index—for example, an overweight to large-cap stocks or an underweight to certain market segments.

Drill down further and you discover another unique aspect: the treatment of initial public offerings (IPOs).

The S&P 500, as well as the S&P MidCap400 and S&P SmallCap600 Indexes, requires that IPOs trade on an eligible exchange for at least 12 months before being considered for addition to the index. This means, for example, that investors in index funds that follow the benchmark would need to wait until 2020 at the earliest to own Lyft, Inc., the popular ride-sharing company that went public earlier this year.

And since Lyft may not be included in the S&P 500 until 2020, it would also be excluded from style indexes derived from the stocks in the S&P 500.

Rebalance and corporate action methodologies of major index providers

Rebalance frequency As needed (determined by committee)Quarterly over 5 daysAnnually over 1 daySemiannually over 1 day
Stock-inclusion criteria Rules-based with committee discretion: market cap, liquidity, earningsRules-based, market cap, liquidityRules-based, market cap, liquidityRules-based, market cap, liquidity
IPOs included After a minimum 365 daysAfter 5 daysAfter 5 days or quarterlySemiannually

Sources: Vanguard and Standard & Poor's. All data as of April 30, 2019.
² Criteria represent S&P 500, S&P MidCap400, and S&P SmallCap600. S&P Total Market and other indexes utilize different rules.

Approximately the 500 largest companies

The current number of stocks in the S&P 500 is actually 505*—not 500 exactly, but not far off either. However, when comparing the 500 largest companies in the S&P Total Market Index with those in the S&P 500, one finds that 60 names from the S&P Total Market Index, accounting for $950 billion in market cap, have been replaced with 60 smaller companies in the S&P 500, representing $470 billion in market cap.

Keep in mind, the S&P 500 is technically a large-cap index. However, while the largest cap is Apple Inc. ($1 trillion), the smallest is Mattel, Inc. ($4.2 billion). Meanwhile, the top 500 actually ranges from $1 trillion to $9.3 billion (Avery Dennison Corp.).

Why is this?

First, the S&P 500, S&P MidCap400, and S&P SmallCap600 are governed by a committee that exercises discretionary application of the rules governing inclusions and exclusions, as well as the cadence of rebalancing. By contrast, most other major indexes have a strict, rules-based approach and structured rebalance schedules.

For example, MarketAxess was added to the S&P 500 on July 1, 2019, replacing L3 Technologies, which was acquired by Harris Corp. MarketAxess—which was a constituent of the S&P MidCap400—has had a market cap ranging from $6.7 billion to $11.8 billion over the past year,* while the market cap of Mattel, Inc.—the smallest holding in the S&P 500—has ranged from $4.2 billion to $6.0 billion over the same period. In fact, even at the lowest market cap point over the past year, MarketAxess had a larger market cap than the 30 smallest names in the S&P 500, yet remained in the S&P Midcap 400.

Second, while most other major indexes are purely market-cap-weighted, S&P includes additional screening criteria for inclusion in the S&P 500, S&P MidCap400, and S&P SmallCap600 Indexes.

For example, to be included, companies must have four consecutive quarters of positive earnings. It's why Tesla, Inc. remains excluded from the S&P 500, even though its IPO was in 2010.

But while mandatory for inclusion, a lack of profitable quarters doesn't mandate subsequent exclusion. While Tesla hasn't been able to crack the S&P 500 Index, GE has remained despite posting a $23 billion loss in 2018.

A different kind of index

The S&P 500 is a large-cap index with a quality-factor bias (based on the earnings screen), and it includes active decision-making by a committee regarding stock inclusion, exclusion, and index-rebalance scheduling. As a result, it's not necessarily a great fit with other mid- and small-cap indexes. As with the S&P 500 Index, the S&P MidCap400 and S&P SmallCap600 Indexes create a similar contrast with other major indexes based on the active committee discretion ingrained in the methodology for inclusion. When combined, the three indexes do not comprise the total market but rather approximately 1,500 of the more than 3,700 stocks in the U.S. market.

Compared with a cap-weighted, rules-based index, which intends to duplicate the returns of all or part of a specific market, the core S&P lineup offers something different. Index fund investors seeking cap-weighted, broad-market exposure will need to pair the S&P 500 with a fund tracking the companion S&P Completion Index and maintain appropriate weightings between the two, which vary based on market movements but are generally about 80% for the S&P 500 Index fund and 20% for the S&P Completion Index fund.

S&P Completion Index is specifically designed to plug the holes (e.g., Tesla) in the S&P 500 Index, while also filling in mid- and small-cap exposure, leading to the consistent cap-weighted total market exposure that investors would get from a fund like Vanguard Total Stock Market Index Fund.

The S&P 500 Index was the basis for Vanguard's first index fund, launched in 1976 as the first index fund available to retail investors. Forty-four years later, Vanguard has more than $675 billion in assets benchmarked to the index.*

The index is a valuable investment for investors looking for large-cap exposure with a quality bias. But it shouldn't be confused for a purely rules-based, market-cap-weighted benchmark.

Put in poetic terms, the S&P 500 may have more in common with the deliberately irregular, improvisational bent associated with free verse poets than the rigid structure associated with those who compose sonnets.

* As of April 30, 2019.


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