underwent a stock split of 4 for 1 in 2020. Its weight in the Dow instantly dropped by 75% due to the new lower share price, because there were now 75% more shares. Was Apple suddenly three-quarters less important or influential as a company than it was the day before? Of course not.
Better but flawed. Compared to the Dow, the S&P 500 is a much better index. It is weighted by market capitalization, which incorporates both share price and number of shares, and it represents the 500 largest companies on that metric. The Nasdaq 100 Index follows the same methodology but is focused on 100 handpicked tech stocks. Given the S&P 500’s better weighting methodology and larger breadth, it’s of little surprise that it has grown to be the most widely used. But in our view, over the years the S&P 500 has become less representative of the U.S. economy, increasingly risky and less helpful as a performance measurement tool.
Indexes were originally created to represent the overall market. But since the growth of passive investing, which uses the index as the investment portfolio, indexes have morphed from simple yardsticks into hugely profitable products. Index owners earn fees on assets and funds that track their indexes. Today there are trillions of dollars in ETFs and funds that track the S&P 500, generating hundreds of millions of dollars in revenue for S&P Global each year.
The S&P 500 index is today controlled by an internal committee of S&P Global employees, which has ultimate discretion over company inclusion or exclusion, as well as sector allocations. It has a clear incentive to ensure the index remains attractive to investors. After all, if investors think the S&P 500 is too risky they might instead buy an ETF linked to a Russell or MSCI index, which would mean lost revenue for S&P Global.
Diverse how? So when a single sector like technology doubled in size over a decade, as it did recently, going from 18% 10 years ago to almost 40% today, that can lead to investor concern over risk and lack of diversification, potentially causing investors to move to other indexes. In 2018, S&P Global created a new sector called Communication Services, into which many of the technology names were moved, thus dropping the overall technology weighting of the S&P 500. At the time, the justification for this change was to reflect the changing economy, but it also had the effect of making the S&P 500 look more diversified and therefore less risky to investors, even though one could argue that the real exposures (and therefore risks) remained entirely unchanged.
Then, there is the S&P 500’s utility as a performance comparator to consider. Many investors have noted how much the S&P 500’s valuation has fallen in recent months and how its multiple today compares to periods of previous drawdowns. But these comments are meaningless due to the fact that the composition of the S&P 500 changes hugely over time, both in sector terms but also in individual company terms (this is also the case with most indexes). The S&P 500 five or 10 years ago was vastly different than it is today, so comparing index multiples across time periods is comparing apples and oranges.