If you own an S&P 500 fund, here's what's happening: Either you're dramatically overinvesting in a relatively small number of giant companies or you're investing as if the fortunes of U-Haul (to pick a company at random) and Microsoft were equally important to your future Financial.
Most likely, you do the former, as almost all of the S&P 500 indices do
Funds are weighted, meaning that companies with higher total market capitalizations make a much bigger difference than smaller companies.
For example, an S&P 500 cap fund has about 200 times as much as Microsoft MSFT
(Total market cap = $2.8 trillion) Same as U-Haul UHAL
(Total market capitalization = $13.8 billion).
If you own an equal-weighted fund, you own as much stock in U-Haul as you do in Microsoft — and in every other stock in the S&P 500.
What is the big deal?
Many investors are comfortable that the S&P 500 allows them to diversify into 500 companies.
However, when you see that the index moves up or down on a given day, about a third of that “action” comes from the 10 largest companies in the index: Apple AAPL,
Microsoft, Amazon AMZN,
Nvidia ran out,
Alphabet Class A Google,
Meta Meta platforms,
Alphabet Class C GOOG,
Tesla TSLA,
Berkshire Hathaway BRK,
and Broadcom AVGO.
Apple and Microsoft themselves represent about 14% of the index value. (Apple's concentration is actually greater; The Motley Fool recently reported that Apple shares make up nearly half of Berkshire Hathaway's portfolio.)
A subset of these giants known informally as The Magnificent Seven (Amazon, Apple, Alphabet, Meta, Microsoft, Nvidia, and Tesla) will account for nearly two-thirds of the index's total gains in 2023.
If you're hoping to diversify between larger, more familiar companies, you may want to include companies like Intel INTC in your investments,
My Coca-Cola,
Walt Disney Dis,
Delta Airlines DAL,
Boeing BA,
Pfizer PFE,
and American Express AXP.
In most S&P 500 index funds, stocks of those seven companies combined make up less than 3% of the portfolio.
Which is better: equal weight or maximum weight?
Only you can decide which type is best for you. Here are three ways you can look at the question.
Philosophically, the hugely popular value-weighted index funds don't give you as much meaningful diversification as you might think. The vast majority of those 500 names don't make much difference.
By that measure, I would vote for equal weighting.
Psychologically, a value-weighted fund will be more comfortable, with returns that follow what you read about and what you've heard about. If you own an S&P 500 equal fund, your returns won't track what's in the news, and that can be worrying.
By that measure, I would vote for a maximum weighting.
Financially, it's a tougher call. Your first question is probably: What type of fund performs best? Answer: It depends.
Fortunately, we can make a comparison going back to the end of 1987, looking at the returns of the Vanguard 500 Value-Weighted Index Fund VFINX and the Invesco Equally Weighted S&P 500 Fund
Fadex Fund.
Since December 31, 1987, the Vanguard fund has compounded 10.7%, and the Invesco fund has compounded 10.9%. Although this seems very close, over that long period, the initial investment of $10,000 would have grown to $399,341 in VFINX versus $414,646 in VADDX.
Future returns will depend on a variety of unpredictable things.
When mega-cap stocks perform better, value-weighted funds will shine. When small stocks lead, an equal-weighted fund is more likely to outperform.
For investments in taxable accounts, the choice is a no-brainer: Choose a cap-weighted fund. The reason: In order to keep the weights of 500 stocks equal, managers of an equal-weight fund would have to make 10 times as many trades, each of which generates what accountants call a tax event for the fund.
I found a Morningstar calculation that shows within a taxable account, VFINX investors in the top tax bracket would lose 0.3 percentage points of return in taxes, versus 2.2 percentage points for VADDX shareholders.)
Otherwise, it's your choice. Most investors, perhaps without realizing the full implications of this decision, choose a weighted variety.
Looking to the future
I won't try to predict the future, but I can't help but wonder how many, if any, of today's “Big Ten” stocks will still be dominant 36 years from now.
Only three of the 10 largest companies in the S&P 500 today existed in 1987. There was no Tesla, no Netflix, no Facebook or Google.
Here are the 10 largest stocks in the S&P 500 at the time, ranked by revenue rather than total stock market value:
-
General Motors GM
-
Exon XOM
-
ford f
-
IBM International Business Machines
-
Mobile
-
General Electric GE
-
AT&TT
-
Texaco
-
DuPont DD
-
Chevron CVX
Each of these companies is still part of the S&P 500, although Mobil is now part of Exxon and Texaco is part of Chevron.
Only Exxon Mobil is among the top 20 stocks in the S&P 500 today. Chevron Texaco 24 yearsyIBM, once a dominant technology giant, is now 49 years oldy. GM fell to 164yFord to 171street and DuPont to 251street.
Together, these former giants make up just 3.01% of today's index.
There are two obvious takeaways from all of this. First, things change. Second, the cap-weighted index reflects those changes and automatically keeps up with the times.
I won't be around in 2060. But I'm willing to break the rule of unpredictability, and I guarantee the composition of the S&P 500 will look very different then.
If you've been following Chris Pedersen's 2 Funds for Life strategy, I recommend his latest videos. And if you want my assessment of the markets in 2023 and my predictions for 2024, you'll find them in my latest podcast.
Richard Buck contributed to this article.
Paul Merriman and Richard Buck are authors of We're Talking Millions! 12 simple ways to boost your retirement.
