The Anatomy of an Index: The S&P 500

Did you know that an estimated $15.6 trillion in assets are indexed or benchmarked to the Standard & Poor’s 500 Composite Index, including nearly $7.2 trillion in index assets?¹

The S&P 500 is ubiquitous – we see it on the news, read about it in the newspapers, and very likely, see some of our own investments’ performance compared against it. For an index that represents approximately 80% of the value of the U.S. equity market, it may be worthwhile to gain a better understanding of how it works.¹

Cap & Criteria

The index, as we know it today, was introduced in 1957 and is maintained by Standard & Poor’s Index Committee. Contrary to popular belief, it is not comprised of the 500 largest companies in America, but is a collection of large-cap stocks representing a broad range of market sectors, including technology, energy, health care, and consumer staples, among others.²

There are a number of criteria a company must meet to be considered for inclusion in the index. Some of these criteria include the following:

• be a U.S. company
• have an unadjusted market capitalization of $14.6 billion or more
• have 50% of its stock available to the public
• have four consecutive quarters of positive earnings.²

Changes Over Time

Another common misconception is that the index is a static one. In fact, companies will be removed from time to time for reasons that include violation of one or more of the criteria used for adding companies or because of a merger, acquisition, or significant restructuring, including bankruptcy.

The turnover in the index’s constituent companies was 3.6% in 2020 (per the most recent data available). According to one projection, the average tenure of companies in the index is expected to fall to 15-20 years this decade, as compared to the 30-35 year average tenure in the late 1970s.³

Add and Subtract

When changes are made to the index, many mutual funds and exchange-traded funds that seek to replicate the index may have to sell stocks that are being removed and buy the stocks that are being added in order to track the index. Keep in mind that amounts in mutual funds and ETFs are subject to fluctuation in value and market risk. Shares, when redeemed, may be worth more or less than their original cost.

Although many investments are commonly compared to or benchmarked to the S&P 500, the S&P 500 may not always be the right index to compare or benchmark to. Since the S&P 500 is an index of large cap stocks across different sectors, it's not an appropriate benchmark for all sectors or all classes of investments, including small cap stocks, value stocks, real estate, and more.

Investing in the S&P 500

Investors cannot invest in an index. Instead, investors can invest in funds that attempt to replicate the index. Also, index performance is not indicative of the past performance of a particular investment, and past performance does not guarantee future results. Investment choices designed to replicate any index may not perfectly track it, and their returns will be reduced by fees and expenses.

Only investing in a fund that's designed to replicate the S&P 500 may not fully diversify an investment portfolio since it's limited to large cap stocks. A fully diversified investment portfolio would include mid-cap and small-cap stocks, growth and value stocks, commodities, real estate investments, alternatives, and more. With a properly diversified portfolio, a different benchmark, or a combination of different indexes as benchmarks, would be used to compare the investment portfolio to so that the asset allocation of the investment and benchmark matches better

Investing in a mutual fund or exchange-traded fund (ETF) that is trying to replicate the S&P 500 may seem like an easy investment, but it may not be the best investment. Your investment portfolio should match your goals, time horizon, and risk tolerance, among other factors. That may seem more complicated, but it can be a better and safer investment option.

Fortunately, enlisting a financial advisor can help you navigate your investment decisions, as well as help you establish goals and a plan to achieve those goals through wise investment decisions, Feel free to...