By Dan Hallett on November 6, 2024
It’s hard to believe that many investors were repelled by the idea of buying U.S. stocks in the early 2010s. A decade and a bit later, most investors are infatuated with U.S. stocks. The S&P 500 Index of larger U.S. companies is the most widely followed market barometer. There are good reasons to like this index for U.S. stock market exposure. It tracks mainly larger companies. It is easily investable via many low-fee investment funds. And it has been a tough benchmark to beat. But there are a few characteristics about this popular index that will surprise most.
Not just the 500 largest companies
Using financial database FactSet, I filtered for all U.S. public companies and ranked them by market capitalization or “market cap” (i.e., the total number of shares outstanding multiplied by the share price). I replicated this ranking for the S&P 500 constituent stocks.
The group of the largest five hundred stocks sports average and median market cap figures that are slightly higher than the S&P 500. But the smallest company in the S&P 500 has a market cap of $6.8 billion – less than half of the $16 billion market cap of the 500th largest U.S. public company. Moreover, eighty-eight (or 18%) of the S&P 500 stocks have market caps smaller than $16 billion. (All dollar figures are in USD unless otherwise noted.)
The S&P 500 is a factor strategy
In addition to the size of a stock’s market cap and adequate liquidity, this index also requires each company added to pass a “financial viability” criterion – i.e., positive net income in the most recent quarter and over the most recent four quarters. When most investors think of a factor strategy, they may think of more elaborate quantitative strategies to select stocks. But choosing only stocks that recorded recent profits is a factor just like value, momentum, low volatility, dividend growth, or other stock characteristics used to avoid inferior stocks. For example, Tesla was not added to the index until late 2020; the first time that the electric vehicle manufacturer had posted a full year of positive earnings.
The S&P 500 is an active strategy – sort of
Each stock market index has rules that define which stocks are included. Those same rules are used to remove some companies and add replacements. The S&P 500 is no different. Each year, several stocks are dropped, and new ones are added. For example, more than 1/3rd of the S&P 500 constituent stocks from a decade ago are no longer in the index thanks to acquisitions and removals. Similarly, just five of the top fifteen holdings from a decade ago remain in the top ten.
This is modest turnover by industry standards. Still, it might be considered high for a “passive” index. But there is more to S&P 500 changes than quantitative rules. Standard and Poors, the index sponsor, has an index committee that finalizes removals and additions. Most changes are purely rules-driven, but the committee can deviate from those rules. Many years ago, I asked the firm how the index committee makes its decisions.
The email response (which I shared on Twitter a few years ago) said that they examine a company’s historical earnings, revenue, cash flow, debt, book value, etc. They also highlighted wanting to make sure that any company added would still be in business in a year or two in an attempt to avoid embarrassing selections (e.g., failed energy company Enron was removed in 2001).
Given that S&P’s index selection committee can deviate from the index rules, it is worth exploring the performance impact of the annual index changes. In the 2006 paper Long-Term Returns on the Original S&P 500 Companies (Financial Analysts Journal, Volume 62 – Issue 1), authors Jeremy J. Siegel and Jeremy D. Schwartz calculated the performance of the S&P 500’s original stocks from March 1957 through 2003 – and compared this with the actual index (with all of its changes). They found that simply buying and holding the original group of stocks outperformed the S&P 500 with less risk. I am not aware of a more recent analysis but would love to see Siegel and Schwartz update their excellent work.
These characteristics don’t invalidate the S&P 500 index as a strategy. But they highlight lesser-known traits and underscore that most strategies involve some form of active management decision.
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