Think You’re Not Heavily In Tech? Think Again.

Weighted Indexes Inadvertently Expose Investors To Big Tech

Amazon, Facebook, Apple, Google and Microsoft Now Account for Nearly 20% Of The S&P500 Index

In his 1994 classic ‘Stocks For The Long Run: The Definitive Guide to Financial Market Returns and Long-Term Investment Strategies’, Jeremy Siegel writes: ‘Trying to beat the market leads to disastrous results…our actions lead to much lower returns than can be achieved by just staying in the market.’

Using data stretching back to 1802, Siegel argued that trying to beat the market over the long run is worthless, and savvy investors should opt for passively-managed index funds, now known as ETFs, as the safest and most diversified bet for long term investment success. 

Weighing The Market

Today, millions of individual investors continue to heed Siegel’ s buy-and-hold wisdom, parking their savings in ETFs like the SPDR S&P 500 (SPY) which tracks the index of the 500 largest publicly-traded companies in the US.

The S&P500 index is ‘weighted’ by market capitalization, so that each underlying stock’s performance is reflective of its value in the overall index. Companies with larger market caps have a greater impact than smaller companies on how the index performs overall. 

The meteoric rise of the so-called mighty ‘FAAG’ shares – Facebook, Apple, Amazon and Google – along with Microsoft, has skewed the S&P500 so much that they now account for 17% of the index’s market capitalization. When five shares hold such a large weighting, they play a major role in the ups and downs of the overall index, counteracting the objective of providing investors with diverse exposure to lots of sectors and areas of growth. For the millions of passive long-term investors that buy S&P500 ETFs, they are, unwittingly, actually betting heavily on US tech. 

Weighing Down The Market

To be fair, the ‘FAAG+M’ shares have buttressed the S&P500’s recovery from its Coronavirus-induced tumble back in March, pushing it 13% higher since this time last year.

But technology an economy does not make, and the ballooning share prices among a handful of stocks is an uneasy signal of a pricing bubble. It’s no secret that Wall Street thinks big tech shares are overheated, and their overweighted influence on the S&P500 is worrisome. When the index becomes overly sensitive to certain shares, it also becomes less diversified across other areas of the real economy, leading to a divergence between the performance of the index and what’s happening in the broader economic landscape.

To emphasize how weightings can distort returns, let’s look at the following example: 

Let’s pretend the S&P Index only contained two shares: Apple (AAPL) and Mattel (MAT). The shares would be weighted according to the following calculation: 

AAPL market cap: $2,000bn
MAT market cap: $4.2bn
Total Market Cap: $2,004.2 bn

APPL weighting = $2,000bn/$2,004bn = 99.8%
MAT weighting = $4.2bn/$2,004bn = 
0.2% 

Let’s say scientists discover Barbie dolls can cure Coronavirus. Shares in Mattel, which makes Barbie dolls, rocket 1,000% in one day, from $12 to $132. Meanwhile, AAPL shares fall slightly by 0.1%, from $115 to $114.89.

If the Apple-Barbie index ETF was trading at $100/share that day, it would gain just $2, or 2%, to $102/share despite Mattel comprising half the companies in the index. That doesn’t seem very fair!   

(99.8% * -0.1%) + (.2% * 1000%) = 2% total gain
$100/share * (1 + 2%) = $102/share

Equal Weighted Exposure

 Some market analysts believe an index that weighs each company equally offers investors a more accurate exposure to the domestic economy and prevents high-flying tech shares from stealing too much of the performance spotlight.

The Guggenheim Equal Weight S&P500 ETF (RSP) offers access to the same companies as the regular S&P500 but gives each stock an allocated 0.2% weighting, so the big hitters like Apple and Amazon play just as important a role as smaller players like Campbell Soup Company, Gap Inc and Western Union.

In our Barbie-iPhone ETF example, if the shares were equally weighted at 50%, our 1-day gain would have a very different outcome, and our $100 ETF would jump 499.95% to $599.95: 

(50% * -0.1%) + (50% * 1000%) = 499.95%
$100/share * (1 + 499.95%) = $599.95

Final Thought: What Is The ‘Stock Market’?

Rightly or wrongly, the S&P500 index serves as a benchmark for the stock market at large as well as an important arbiter of the economy’s health, both domestically and on the global stage.

With big tech playing such an overweight role in the index, the implications go beyond share price movements and raise questions about their broader role in shaping how Americans feel about their country, prosperity and opportunity. When Apple issues positive news and the share price goes up, the stock market goes up too. When did the iPhone embody the health of our nation’s economy? Or Facebook?

For the millions of investors who subscribe to Siegel’s buy-and-hold long-term wisdom, the implications of weighted indexes go beyond their value in our pension portfolios and touch upon the fundamental drivers of our nation’s identity, both now and in the future.