The S&P 500 Index: A View Into the Popular Index
When it comes to investing, market index funds have emerged as a popular and strategic choice for many investors. These funds offer an avenue to gain exposure to a diversified collection of assets while mirroring the performance of a specific market index. When choosing index funds, it is important to understand how the index is constructed as the rules behind the index will impact how the index performs.
Before we dive into the intricacies, let’s establish what a market index fund is. A market index fund is a type of mutual fund or exchange-traded fund (ETF) that is designed to replicate the performance of a specific market index. Examples of market indexes are the S&P 500 Index, the US Total Stock Market, the Dow Jones Industrial Average, and the Russell 2000 Index. Indexes are not limited to just stocks. A popular bond index is the Barclays US Aggregate Bond Index. There are many broad indexes and many specialized indexes that can cover a particular sector, theme, country, or strategy.
Why Index Funds are Important Investment Tools
The beauty of a market index fund lies in its simplicity and adherence to the principles of the underlying index. Here are the core components that comprise a market index fund:
Index Replication: A market index fund aims to replicate the performance of a particular index as closely as possible. This means that the fund will hold a similar mix of securities, mirroring the index’s selection and weighting criteria.
Diversification: A common attribute for most index funds is diversification. It is not uncommon to see an index fund with hundreds or even thousands of positions within a single fund. This broad diversification means that the performance of any single stock will not significantly increase or decrease the overall performance of the fund. It is important to note that there are certain index funds that can be concentrated in a small group of stocks or own fewer than 100 underlying stocks depending on the index tracked.
Passive Management: Market index funds are typically managed passively, which means they don’t involve frequent buying and selling of securities and they do not need to hire a large research team for stock selection. This approach helps keep costs lower compared to actively managed funds.
Accessibility: Market index funds are widely accessible through various investment platforms, making them convenient for investors of all background. Additionally, index funds allow smaller investors to gain diversification through as few as two funds!
This article will use certain financial terminology. If you are unfamiliar with a particular term, see the definitions section at the end of the article.
Now that we have covered some of the basics, let’s take a look at the most significant index in the world: the S&P 500.
The S&P 500
The S&P 500 Index is significant in several ways. It contains some the largest companies in the world (but not all) and owns a large percentage of the market capitalization of the US stock market. It is one of the most common options available for investment in retirement plans such as 401(k) plans or 403(b) plans. Many active managers use the S&P 500 Index as their benchmark for performance.
The S&P 500 Index is a full replication, fixed number of constituents, market capitalization weighted index. More specifically, the S&P 500 owns every single of the largest 500 stocks and weights them according to how large each company is. If you dive into specific weightings, a few things stand out.
First, the top 10 stocks in the S&P 500 account for more than 30% of the index investment. This means that if you invested $100,000 an S&P 500 index fund, roughly $30,000 of that is going towards these top 10 companies. Breaking that down further, approximately $7,600 is going to Apple and $6,600 is going to Microsoft.
Second, the weighting of the top 10 companies is also increasing and currently sits at all-time highs. This is largely due to the significant concentration of outperformance in a few technology companies.
Source: FactSet, Standard & Poor’s, J.P. Morgan Asset Management. Guide to the Markets – U.S. Data are as of July 31, 2023.
The top 10 S&P 500 companies are based on the 10 largest index constituents at the beginning of each month. As of 6/30/2023, the top 10 companies in the index were AAPL (7.7%), MSFT (6.8%), AMZN (3.1%), NVDA (2.8%), GOOGL (1.9%), TSLA (1.9%), Meta (1.7%), GOOG (1.7%), BRK.B (1.6%), UNH (1.2%) and XOM (1.2%). The remaining stocks represent the rest of the 494 companies in the S&P 500.
If we were to break down the $100,000 investment further into five increments of $20,000, here is how many companies you would own in each increment:
| Increment | Companies Owned | Investment Per Company |
| $ 20,000 | 5 | $ 4,000.00 |
| $ 20,000 | 21 | $ 952.38 |
| $ 20,000 | 46 | $ 434.78 |
| $ 20,000 | 112 | $ 178.57 |
| $ 20,000 | 316 | $ 63.29 |
At the top, 5 companies split the first $20,000 for an average of $4,000 invested in each company. At the bottom, 316 companies split the last $20,000 for an average of $63.29 invested in each company.
Investment Implications
Investing in index funds, like the S&P 500, can be a smart way to grow your wealth over time and a great option for many investors. However, you should also be knowledgeable of how the index is constructed and limitations of this approach. The S&P 500 is not a perfect representation of the U.S. stock market or economy, and is increasingly reliant on the performance of the top 10 stocks. When these stocks do well, the index does well. But when these stocks do poorly, the index also can have poor returns.
When using the S&P 500 in portfolio construction, it is important to consider what investments compliment the index or mitigate the risks. For example, owning an investment that tracks the Russell 1000 would be overlapping many of the positions you already own. However, owning an investment that tracks the S&P 400 or S&P 600 would have no overlap and provide exposure to different areas of the market resulting in more diversification.
Helpful Definitions
Index: A method of tracking the performance of a group investments like stocks, bonds, or real estate.
Constituents: The stocks selected for an index.
Common Constituent Selection Methods (Which Stocks are Eligible for the Index)
Target Number of Constituents: The index targets a specific number of stocks in the index. The number of stocks represented will not change but the actual constituents will change over time as companies grow or shrink. For example, the S&P 500 owns the largest 500 US stocks, the S&P 400 owns the next 400 largest US stocks, the S&P 600 owns the next 600 largest US stocks below that. The Russell 1000 Index owns the largest 1,000 US stocks.
Target Percentage of Market: The index targets owning a certain percentage of the stock market. The percentage of the market will stay consistent over time but the number of constituents will change. For example, the CRSP Large Cap Index seeks to own 85% of the total publicly traded market which equates to ~450 of the largest companies. As a reference point, the S&P 500 covers ~86.6% of the market. The CRSP US Small Cap Index seeks to own stocks in the 85% to 98% of total market capitalization which means it owns over 1,100 stocks.
Industry: An index can target stocks in a specific industry such as Information Technology, Utilities, Health Care, and Financials.
Country: An index can target stocks located in specific countries or geographic regions.
Common Constituent Weighting Methods (How to Weight the Eligible Stocks in the Index)
Market cap-weighted index: The weight of each stock is proportional to its market capitalization, which is the product of its share price and the number of shares outstanding. For example, if a company has 1,000,000 shares outstanding and trades at $500 per share, the market capitalization is $500 million. A larger company has a bigger influence on the index. So, if you have another company with a market capitalization of $500 billion, it will have more than 10x the weight in the index.
Price-weighted index: A higher priced stock carries a higher weighting in the index. An equal number of shares of each security is purchased, and the beginning divisor is usually set to the total number of shares in the portfolio. The most popular Pric-Weighted Index is the Dow Jones Industrial Average.
Equal-weighted index: Each stock is given the same weight in the index, regardless of its price or market cap. This method avoids the bias of the previous methods, but it requires frequent rebalancing and may incur higher transaction costs.
Fundamentally-weighted index: The weight of each stock is based on fundamental factors such as earnings, dividends, and book value. This method aims to capture the intrinsic value of the companies, but it may involve subjective judgments and data issues.
Index Replication
Depending on the index, the replication process may be one of the following:
- Full Replication: The fund attempts to own exactly what is contained in the index at the exact percentages specified. This method will yield the lowest tracking error or deviation from the index performance.
- Approximate Replication: The fund attempts to create a basket of securities in the index that will follow the overall performance of the index without owning every single position in the index. While the fund performance will be close to the index, there will be deviations either positively or negatively from index performance.
- Synthetic Replication: The fund uses complex derivatives such as swaps or stock options to replicate an index performance.