The S&P 500 is the most highly regarded stock market index and many consider it yo be the barometer of the United States’ overall stock market performance. The S&P 500 includes 500 of the largest public companies in the U.S. and covers all 11 market sectors and many industries. The index reflects the health of the stock market and the U.S. economy, and as such is a benchmark for the U.S. economy as a whole.
Companies based outside of the U.S. can be part of the index, but they must list on either the New York Stock Exchange (NYSE) or the Nasdaq. However, in practice, the vast majority of companies in the S&P 500 are based in the U.S. Furthermore, they must meet all the other S&P 500 inclusion selection criteria. Please, also note, that the S&P does not include any privately held companies.
This article takes an in-depth look at this index, its calculation, history, use, iadvantages and disadvantages, and the differences between the S&P 500 and the Dow Jones Industrial Index (DJIA).
What Is the S&P 500?
The Standard & Poor’s 500 Index or S&P 500, has several different ticker symbols such as SPX, INX, and ^GSPC, dependent on the market or website that uses and publishes it. The S&P Dow Jones Indices, a joint venture between S&P Global and Dow Jones, maintains it.
This stock market index is an excellent metric of large-cap equities on big exchanges like the Nasdaq and the New York Stock Exchange (NYSE). The companies in this index comprise about 80 percent of the equities’ total market capitalization in the U.S.
Reuters updates the S&P 500 every 15 seconds on trading days, with price updates publicly made available. As a result, it is a real-time indicator of the performance of the U.S. stock market. Investors often use it as a benchmark for comparing other investments.
The S&P 500 index is one of the 3 most popular indexes in the U.S. markets. The other 2 are the Dow Jones Industrial Average, and the Nasdaq Composite index. Another important index is the Wilshire 5000 index, which includes all the stocks from the U.S. stock market.
S&P Inclusion Selection Criteria
The S&P 500 includes 500 large-cap public U.S. companies representing all major industries. Despite its name, it comprises 505 common stocks issued by 500 large-cap companies. There is a set of requirements that a company has to meet for admission to the index. The U.S. Index Committee determines whether a company will be included in the index or not. Here are some of these requirements:
- The company must be based in the United States
- It must have at least 50 percent of stocks available to the public
- Have a market capitalization of at least $8.2 billion
- At least 50% of its fixed assets should be in the US
- It must be listed on the NYSE, the Nasdaq, or BATS Global Markets or Investors Exchange (IEX).
- Its stocks cannot be traded OTC or on Pink sheets
- The stock price must be higher than $1 per share
- Its most recent quarter’s earnings and the sum of its trailing four consecutive quarters’ earnings must be positive
The committee meets once a month to discuss possible changes. The committee reviews and updates the list quarterly. Furthermore, the committee rebalances the index quarterly in March, June, September, and December. Since a committee selects the companies in the index, there are always controversial omissions and inclusions. For example, Real Estate Investment Trusts (REITs) were first eligible for inclusion in the S&P 500 in 2001.
One of those controversial decisions was announced in September 2020. On September 8, the committee said “No” to admitting Tesla but said “Yes” to 3 other companies. As a result, Etsy (Nasdaq: ETSY), Catalent (NYSE: CTLT), and Teradyne (Nasdaq: TER) were added to the index. The committee removed Kohls, Coty, and H&R Block.
There was a lot of speculation about the possible admission of Tesla to the famous stock index, but, contrary to Wall Street’s forecasts, the committee finally decided not to include Tesla. The market reacted immediately, and as expected, Tesla’s stock price took a nose dive the day the announcement was made. Tesla’s stock dropped 21% that day, the worst daily decline ever for Tesla. In one week, Tesla’s stock dropped a total of 34%. The committee never publicly announced why Tesla didn’t make it into the S&P index, but many experts believe the reason for non-inclusion was Tesla’s overvaluation of its stock.
Sometimes companies lobby for inclusion in the index for various reasons. One of the reasons is the prestige and widespread respect and admiration comes with being part of the index. However, the main reason for wanting to be a S&P 500 company is that a company’s share price usually significantly increases after inclusion to the index. This price increase partly happens because fund managers have to buy this stock to replicate the S&P 500 index in their fund, and this increased demand for the shares will drive the share price up.
How Is It Calculated and What Does It Measure?
The S&P index is a market capitalization-weighted index, which means that company’s weight in the index reflects its market capitalization or market value. The higher the company’s market cap, the higher its weight in the index. The formula for company weighting is:
Free-float adjusted market cap = number of outstanding shares available to the public x current share price
A company’s market capitalization is easy to calculate. You take the current stock price and multiply it by the number of its outstanding shares. For purposes of determining the market cap of a company for weighting in the S&P 500 index, only the shares available for public trading (free-float shares) should be used. Locked-in shares should not be included. For example, if a company has 2 million outstanding shares available for public trading, and the current share price is $10, its market cap is $20 million.
Company weighting = company market cap / total market cap of the S&P 500
Then, to determine each company’s weight in the index, you need to divide each company’s float-adjusted market cap by the index’s total market cap. You can calculate the index’s total market cap by adding up the float-adjusted market caps of all the individual companies in the S&P 500.
Luckily, the total market cap for all the companies in the S&P 500 (the divisor in the weighting formula) is published regularly on financial websites. On August 31, 2020, the S&P 500 had a total market cap of $28.94 trillion. The value of the market caps of each company gets published as well. With the availability of this information, it is easy to calculate the weighting of each company in the index.
The S&P does not disclose the exact calculation for the Divisor.and keeps the algorithm it uses proprietary. For this reason, many investment companies estimate and calculate their own divisor.
The market cap range of companies in the index is enormous and can range from a few billion dollars for the smallest company, to a market cap of over $2 trillion, for a big company such as Apple. It is essential to understand that the larger the company’s weighting, the larger the impact each 1% change in its stock price will have on the S&P 500 Index.
Top Companies in the S&P 500
As of August 31, 2020, per S&P Dow Indices, the top 10 companies in the S&P 500 with their weighting were:
- Apple Inc. (AAPL) 7.3%
- Microsoft Corp. (MSFT) 5.9%
- Amazon.com (AMZN) 5.0%
- Facebook Inc. (FB) 2.4%
- Alphabet Inc. Class A (GOOGL) 1.7%
- Alphabet Inc. Class C (GOOG) 1.7%
- Berkshire Hathaway (BRK.B) 1.5%
- Johnson & Johnson (JNJ) 1.4%
- Visa Inc. (V) 1.2%
- Procter & Gamble (PG) 1.2%
Please note that the top 10 companies in the index had a weight of more than 29% in the index.
S&P 500 History and Its Performance
The S&P 500 was formed on March 4, 1957, though its history dates back to 1923, when it was first introduced as an index of a small US stock group. At present, the S&P Dow Jones Indices owns the index. Since 1957, the S&P 500 index has shown an average annual return of about 8% without considering inflation.
Though the overall annual return average is positive, it has seen ups and downs through the years. For example, it dropped by 60 percent during 2008-2009 and spiked by 32 percent in 2013 when the global economy recovered.
The average annual return of the S&P 500 between 1957 and 2018 is roughly 8%. Adjusted for inflation brings this average down to about 7%. Please note that these are averages, and timing can influence these numbers. If you enter the market at a high or exit the market at a low, these averages will be lower. On the flip side, if you enter the market at a low and exit high, these averages will be higher.
How Is the S&P 500 Useful?
Many consider the S&P 500 index to be the best economic indicator of the U.S. stock market’s performance. They believe that because the index covers of 500 of the largest companies that capture 80% of the public stocks available in the US and also covers all industry sectors, that it provides a fair representation of how the U.S. stock market is doing in general.
As an economic indicator of the U.S. economy’s performance it has a big influence on investors. When investors are confident in the U.S. economy, they will buy more stocks. In contrast, when they are pessimistic about the economy, they will hold off buying securities or sell them.
Investors also use the index as a benchmark against their portfolios. Although a company might be profitable and seemingly be doing well, comparing your portfolio’s performance to the S&P 500’s performance is a good way to assess how your portfolio is doing in the general market. The comparison will tell you whether your portfolio is outperforming or underperforming the market.
Many different index funds such as ETFs and mutual funds track the S&P 500. Becasue most investors do not have the time, interest, or knowledge to build a portfolio of individual stocks, they love buying these funds. Investing in a fund that tracks the S&P 500 is a pretty easy investment strategy. It saves time, reduces risk through diversification and brings returns that are on par with the overall market.
Advantages and Disadvantages of the S&P 500
Leading economic indicator – Featuring 500 of the largest U.S. companies from all 11 industry sectors, many consider the S&P 500 to be a leading economic indicator of the performance of the U.S economy. In general, when the S&P 500 is doing well, the economy will be doing well.
Regular updates and recalculations – Another advantage of the S&P 500 is that the committee updates the index components quarterly. In addition, it regularly recalculates the market caps of all companies and makes adjustments for new stock issues. Besides, new companies are added to the index while others are deleted. These regular updates ensure that the S&P 500 accurately reflects the state of the large-cap market in the U.S.
It provides investment opportunities due to its volatility – The volatility of the index is another advantage for investors. Its value changes quickly in response to different factors, such as a change in interest rates. This volatility allows investors to make a profit. Investors can either go short if they think the index’s value will fall or go long if they think its value will rise.
Stocks in the S&P have high liquidity – High liquidity is another positive aspect of the index. Trading volumes for stocks in the S&P 500 are often very high. Traders will have no problems finding buyers or sellers for stocks that make up the index.
Risk of inflated value of the S&P 500 – One of the limitations of the S&P 500 (and other market-cap-weighted indexes) occurs when stocks in the index become overvalued. An overvalued stock has a current price that is not justified by its earnings outlook or its price-earnings (P/E) ratio. So, Wall Street expects the price to drop eventually. When an overvalued stock has a heavy weighting in the index, it inflates the index’s total price.
It excludes private companies and smaller companies – The S&P 500 contains only larger market cap companies from the United States. Therefore, it is not an exact representation of the U.S stock market or the economy. It excludes smaller companies, private companies of all sizes, and foreign companies. Investors who have mid-cap, small-cap, or foreign companies in their portfolios should not use the index for benchmarking.
Because of the exclusion of private and smaller companies, the index is not as good an economic indicator as many people believe it to be. An index that only contains large public companies does not tell the whole economic story. On the contrary, private and smaller firms do have a significant impact on GDP, earnings, and unemployment rates.
It excludes bonds and commodities – Besides stocks, most investors have a diversified portfolio that includes bonds and commodities. Using the index as a benchmark for a diversified portfolio that includes non-stock assets is not a good idea.
It is disproportionately weighted toward larger companies – The top 10 companies of the S&P 500 account for almost 30% of the index’s value. Large price movements of the stocks of this top 10 will skew the value of the index.
How Can You Invest in the S&P 500?
Because the S&P 500 is considered a good representation of the overall U.S. stock market, it is also considered a good investment. Although the index company itself does not issue stocks, direct investment in the index is not possible. However, you can invest in the S&P 500 indirectly through index funds. You can buy Exchange Traded Funds (ETFs) or mutual funds that track the S&P 500 index. These investment vehicles own all the stocks of the index in proportional weights.
Companies such as the Vanguard Group and IShares issue ETFs that track the index. While companies such as Charles Schwab Corporations and Fidelity Investments offer mutual funds that track the the S&P 500.
While ETFs focus on passive replication of the index, mutual funds can be either active or passive. ETFs are highly liquid and subject to fluctuations like stocks.They act like stocks, but they are investment funds. ETFS are great for individual investors because of their liquidity and lower fees due to their passive nature. In contrast, mutual funds can be bought only at the day’s closing price which makes them less liquid.
Those who want to invest cheaply in the S&P 500 ETFs can consider discount brokers who offer commission-free trading on passive products. Both ETFs and mutual funds offer diversification. Purchasing just one share of an index fund that tracks the S&P 500 gives you a chance to invest in 500 companies. Investing in the S&P 500 through a low-cost fund provides a great base for a diversified stock portfolio.
What Are the Main Differences Between the S&P 500 and the Dow Jones?
The number of companies and industries included – The Dow Jones Industrial Average tracks 30 U.S companies. These companies are the most stable, biggest, and famous in their industries. However, the DJIA does not include some of the largest companies in certain industries in the U.S., such as Amazon, Alphabet, and Berkshire Hathaway. The S&P 500, on the other hand, tracks 500 large-cap companies across all the industry sectors.
Because of the larger number of companies included in the index and the index covering more sectors and industries, some investors often consider the S&P 500 a better representation of the American stock markets than the Dow Jones Industrial Average. Retail investor’s typically prefer the the DJIA as a benchmark, while institutional investors generally prefer the S&P 500.
S&P 500 is market-cap weighted, DJIA is price-weighted – The S&P 500 is a market-cap weighted index where higher allocation is given to companies with a larger market capitalization. Remember that market capitalization accounts for both stock price and the number of shares outstanding in the market. On the other hand, the DJIA is a price-weighted index that gives companies with higher stock prices a higher index weighting. Due to the price-weighted system, the DJIA will experience more frequent lows and highs than the S&P 500, as the DJIA’s weighting is based on stock prices only.
Investing in index funds such as ETFs that track the S&P 500 offers good investment opportunities because these funds provide a broad exposure to the American economy’s profitability without relying on the performance of individual companies. Purchasing just one share of an index fund that tracks the S&P 500 gives you a chance to invest in 500 companies. These index funds can generate strong returns in your investment portfolio without much effort on your part if you use a buy-and-hold strategy for the long term.