If you own a S&P 500 fund, here’s what’s happening: Either you’re massively bulking up on a relatively small number of giant companies or you are investing as if the fortunes of U-Haul (to pick a company at random) and Microsoft are equally important to your financial future.
Most likely, you’re doing the former, because almost all S&P 500 SPX funds are cap-weighted, meaning that companies with high total market value make much more difference than smaller companies.
For example, a cap-weighted S&P 500 fund owns about 200 times as much Microsoft MSFT, -0.54% (total market cap = $2.8 trillion) as it does U-Haul UHAL, +1.04% (total market cap = $13.8 billion).
If you own an equal-weighted fund, you own just as much stock in U-Haul as you do in Microsoft — and in every other stock in the S&P 500.
What’s the big deal?
Many investors are comforted by the fact that the S&P 500 lets them diversify into 500 companies.
However, when you see that the index moved up or down on a given day, about one-third of that “action” comes from the 10 largest companies in the index: Apple AAPL, +1.22%, Microsoft, Amazon AMZN, -0.36%, Nvidia NVDA, +0.27%, Alphabet Class A GOOGL, -0.27%, Meta Platforms META, -0.44%, Alphabet Class C GOOG, -0.18%, Tesla TSLA, -1.60%, Berkshire Hathaway BRK.B, +0.29%, and Broadcom AVGO, +0.77%.
By themselves, Apple and Microsoft represent about 14% of the index’s value. (Apple’s concentration is actually greater; The Motley Fool recently reported that Apple shares make up nearly half the portfolio of Berkshire Hathaway.)
A subset of these giants known informally as The Magnificent Seven (Amazon, Apple, Alphabet, Meta, Microsoft, Nvidia and Tesla) accounts for nearly two-thirds of the total gains in the index in 2023.
If you’re hoping for diversification among large, familiar companies, you might want your investments to include companies like Intel INTC, +0.15%, Coca-Cola KO, -0.43%, Walt Disney DIS, +2.17%, Delta Air Lines DAL, -0.80%, Boeing BA, -0.04%, Pfizer PFE, +0.11%, and American Express AXP, +1.00%.
In most S&P 500 index funds, the stocks of those seven companies together make up less than 3% of the portfolio.
Which is better: equal weight or cap weight?
Only you can decide which type is better for you. Here are three ways you can look at the question.
Philosophically, the popular cap-weighted index funds don’t give you as much meaningful diversification as you probably think. The vast majority of those 500 names don’t make a lot of difference.
By this measure, I would vote for equal weighting.
Psychologically, a cap-weighted fund will be more comfortable, with returns that follow what you read about and hear about. If you own an equal-weighted S&P 500 fund, your returns won’t track what’s in the news, and that can be disconcerting.
By this measure, I’d vote for cap-weighting.
Financially, it’s a tougher call. Your first question is probably: which type of fund performs better? The answer: It depends.
Fortunately, we can do a comparison going back to the end of 1987, looking at returns of the cap-weighted Vanguard 500 Index Fund VFINX and Invesco Equally Weighted S&P 500
Fund VADDX.
Since Dec. 31, 1987, the Vanguard fund compounded at 10.7%, the Invesco Fund at 10.9%. Although that looks mighty close, over that long period, an initial $10,000 investment would have grown to $399,341 in VFINX vs. $414,646 in VADDX.
Future returns will depend on a variety of things that can’t be predicted.
When huge stocks are doing better, cap-weighted funds will shine. When smaller stocks are leading, an equal-weighted fund is likely to outperform.
For investments in taxable accounts, the choice is a no-brainer: choose the cap-weighted fund. The reason: In order to keep the weights of 500 stocks equal, the managers of an equal-weight fund have to make 10 times the number of trades, each one of which generates what accountants call a tax event for the fund.
I found a Morningstar calculation showing inside a taxable account, VFINX investors in the top tax bracket would have lost 0.3 percentage points of return in the form of taxes, vs. 2.2 percentage points for VADDX shareholders.)
Otherwise, it’s your choice. Most investors, probably without realizing the full implications of this decision, pick the cap-weighted variety.
Looking into the future
I won’t try to predict the future, but I can’t help but wonder how many – if any – of today’s “Big 10” stocks will still be dominant 36 years from now.
Only three of the top 10 companies in today’s S&P 500 even existed in 1987. There was no Tesla, no Netflix, no Facebook or Google.
Here were the 10 largest stocks in the S&P 500 back then, ranked by revenue instead of total stock market value:
- General Motors GM, -0.54%
- Exxon XOM, -0.13%
- Ford F,
- International Business Machines IBM, +0.79%
- Mobil
- General Electric GE, +1.09%
- AT&T T, +0.78%
- Texaco
- Dupont DD, +0.96%
- Chevron CVX, +0.18%
Every one of those companies is still part of the S&P 500, although Mobil is now part of Exxon and Texaco is part of Chevron.
Only Exxon Mobil is among the top 20 S&P 500 stocks today. Chevron Texaco is 24th, IBM, once a dominant technology giant, is now 49th. GM has slipped to 164th, Ford to 171st and Dupont to 251st.
Combined, these former giants make up just 3.01% of today’s index.
There are two pretty obvious takeaways from all this. First, things change. Second, a cap-weighted index reflects those changes, automatically keeping up with the times.
I won’t be around in 2060. But I’m willing to break my no-predictions rule and all but guarantee that the makeup of the S&P 500 index will look quite different then.
If you’re following Chris Pedersen’s 2 Funds for Life strategy, I recommend his latest video. And if you want my review of the markets in 2023 and my predictions for 2024, you’ll find them on my latest podcast.
Richard Buck contributed to this article.
Paul Merriman and Richard Buck are the authors of We’re Talking Millions! 12 Simple Ways to Supercharge Your Retirement.
Introduction
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Cap-Weighted vs. Equal-Weighted S&P 500 Funds
The article discusses the difference between cap-weighted and equal-weighted S&P 500 funds. In a cap-weighted fund, companies with higher total market value have a greater impact on the fund's performance. On the other hand, an equal-weighted fund gives equal importance to all companies in the S&P 500 index.
Cap-Weighted Funds:
- In cap-weighted S&P 500 funds, companies with high total market value have a larger influence on the fund's performance.
- The article mentions that a cap-weighted S&P 500 fund owns about 200 times as much Microsoft (total market cap = $2.8 trillion) as it does U-Haul (total market cap = $13.8 billion).
- The top 10 largest companies in the S&P 500, including Apple, Microsoft, Amazon, and Tesla, account for about one-third of the index's movement.
- Cap-weighted funds are often chosen by investors due to their familiarity and alignment with news reports and market trends.
- The performance of cap-weighted funds depends on the performance of larger companies.
Equal-Weighted Funds:
- In equal-weighted S&P 500 funds, all companies in the index have equal importance, regardless of their market value.
- The article states that an equal-weighted fund provides diversification among large, familiar companies like Intel, Coca-Cola, Walt Disney, Delta Air Lines, Boeing, Pfizer, and American Express.
- Equal-weighted funds may provide more meaningful diversification across the entire index.
- The performance of equal-weighted funds depends on the performance of smaller companies.
Performance Comparison and Considerations
The article also discusses the performance comparison between cap-weighted and equal-weighted funds and provides some considerations for investors.
Performance Comparison:
- The article compares the performance of the cap-weighted Vanguard 500 Index Fund (VFINX) and the Invesco Equally Weighted S&P 500 Fund (VADDX) since the end of 1987.
- Over that period, the Vanguard fund compounded at 10.7%, while the Invesco fund compounded at 10.9%.
- However, the article notes that an initial $10,000 investment would have grown to $399,341 in VFINX and $414,646 in VADDX, indicating a slightly higher return for the equal-weighted fund.
- It's important to note that future returns cannot be predicted and will depend on various factors.
Tax Considerations:
- For investments in taxable accounts, the article suggests choosing cap-weighted funds.
- This is because equal-weighted funds require more trades to maintain equal weights for all stocks, generating more taxable events for the fund.
- The article cites a Morningstar calculation showing that VFINX investors in the top tax bracket would have lost 0.3 percentage points of return in the form of taxes, compared to 2.2 percentage points for VADDX shareholders.
Future Changes in the S&P 500 Index
The article concludes by discussing the potential changes in the composition of the S&P 500 index over time.
- The author highlights that the current "Big 10" stocks may not remain dominant in the index in the future.
- Only three of the top 10 companies in today's S&P 500 existed in 1987.
- The article emphasizes that the S&P 500 index automatically reflects changes in the market, keeping up with the times.
- The author predicts that the makeup of the S&P 500 index will look quite different in the future.
It's important to note that the information provided is based on the article you shared, and additional research may be required for a comprehensive understanding of the topic.
