Why You Shouldn't Think Of The S&P 500 As A Diversified Basket Of 500 Companies

by: Tim McAleenan Jr.

Today, I wanted to discuss the nuts-and-bolts of the S&P 500 composition. Even though I have always known that the S&P 500 is a free-float capitalization weighted index, it never really hit me until recently what the implications are of composing the S&P 500 along market cap lines. While I always had the idea in the back of my head that a $166 billion company like Coca-Cola (NYSE:KO) would have more weight than a $2.5 billion company like Pitney Bowes (NYSE:PBI), it took me a long time to realize exactly what this meant from the perspective of someone considering an investment in something that tracks the S&P 500.

For instance, let's look at the top five holdings of the Vanguard S&P 500 ETF (NYSEARCA:VOO). They are Apple (NASDAQ:AAPL), Exxon (NYSE:XOM), General Electric (NYSE:GE), Chevron (NYSE:CVX), and IBM (NYSE:IBM). Specifically, let's look at what this means in terms of the allocation of your investment dollars: for every $100 that you invest in the Vanguard S&P 500 ETF, $3.90 gets invested into Apple, $3.10 gets invested into Exxon, $1.70 gets invested into General Electric, $1.70 gets invested into Chevron, and $1.60 gets invested into IBM. In other words, when you are purchasing a basket of 500 companies, you are really putting 12% of your wealth into just five companies alone.

The implication of this statement is that the S&P 500, because it is market-cap weighted, may be much more top-heavy than you realize. At the very least, it turned out to be much more concentrated than I initially realized. For instance, the Vanguard S&P 500 ETF owns $5.7 billion worth of Apple stock. Let's compare that to the weighting of, say, the 400th weighted stock in the S&P 500. That would be Cincinnati Financial (NASDAQ:CINF). The S&P 500 ETF only owns $50 million worth of the insurance firm. Think about that -- the S&P 500 index owns over 100x as much Apple stock as it does Cincinnati Financial. And considering that there are 99 other companies in the S&P 500 index fund that are smaller than Cincinnati Financial, that means that an S&P 500 index owns more Apple stock than the bottom 100 companies in the index combined. I have found that knowledge particularly eye-opening: if I invested in an S&P 500 index fund, a one percent drop in Apple stock would have just as much effect on my returns as the bottom one hundred companies combined dropping by one percent.

The top 10 companies in the S&P 500 index account for 20% of the value. In other words, for every $100 that you invest into such a fund, $20 would go into the five names listed above, plus Microsoft (NASDAQ:MSFT), Johnson & Johnson (NYSE:JNJ), AT&T (NYSE:T), Google (NASDAQ:GOOG), and Procter & Gamble (NYSE:PG). I am not arguing that this is either a good or bad thing, but rather, that it's important that you be aware of what exactly you're buying when you purchase an ownership stake in something that tracks an index like the S&P 500. For instance, Cincinnati Financial could double, and it wouldn't even raise your wealth by one-tenth of 1%. However, if Apple loses a third or so of its market cap, you're going to lose about 1% of your total wealth in the fund.

For me, an examination of the weightings in the S&P 500 taught me that it was foolish to go about thinking that the S&P 500 was really a diversified basket of 500 companies. While that's technically true in form, it's much less true in substance. The top 50 out of the 500 companies, or 10% of the total companies represented, end up accounting for around 40% of your investable dollars. Again, I am not claiming this is either "good" or "bad," but rather, I find it important to have the concrete knowledge that the top 20 holdings in the index represent more of your investment dollars than the bottom 200 companies combined.

There are some implications of this statement that I think are important for investors to consider. When I started writing for Seeking Alpha in August 2011, one of the most common questions I was asked is why I don't invest in an S&P 500 index fund. When you put it in more explicit terms, what they are really asking me is this: Why don't you choose to invest in such a way so that for every $100 you invest, $3.90 goes to Apple, $3.10 goes to Exxon, $1.70 goes to General Electric, and so on. If that kind of allocation satisfies you, then indexing might make sense. If you don't want almost $4 out of every $100 you invest going into Apple, then owning an index fund or ETF might not be the right choice for you.

Most of the advice about whether or not to own an S&P 500 index revolves around whether or not you want to "beat" the market, have the time and expertise to invest, and so on. And those things are all important. But I think there is another dimension to the discussion as well. If you are contemplating making an investment in an index fund, I would look at the composition and weightings of the top 50 or so holdings and ask myself, "Do I want to put almost 4% of my wealth into Apple? Do I want to put 3% of my wealth into Exxon?" and so on. If I liked most of the companies that are in the top 20 or 30 spots of the index, I'd be much more likely to consider making an index fund investment. The S&P 500 isn't this abstract thing that just happened to go up by around 10% annually over a long part of the 20th century. Not too many financial pundits talk about "looking under the hood" to check out the allocations for each company in the S&P 500 tracker, but it's one of the first things I would do if I were seriously considering owning something like the Vanguard S&P 500 ETF in my portfolio.

Disclosure: I am long GE, JNJ. I wrote this article myself, and it expresses my own opinions. I am not receiving compensation for it (other than from Seeking Alpha). I have no business relationship with any company whose stock is mentioned in this article.