I take a great deal of pride in the fact that I can easily explain the main parts of the stock market risk management process I provide to my individual company 401(k) investment advice clients.
Gone are the days of fancy three-color marketing brochures. I could not produce a PowerPoint presentation to save my life. I have not been in an elevator in over a year so my elevator speech is gone. Hell, I don’t even have a business card.
Here is an example I use with my clients to explain the difference between the S&P 500 Capitalization-Weighted Index (SPX) and S&P 500 Equal-Weighted Index (SPXEW).
What is the S&P 500 Index?
The S&P 500 Capitalization-Weighted Index (SPX) is one of the most widely followed and quoted stock market indices. For years, many large and small investors have used this stock market index as an investment performance benchmark.
This index comprises 500 stocks and is a capitalization-weighted. The stocks with the highest market capitalization receive more weight than those with a smaller capitalization.
Currently, Apple Inc. (AAPL) has the highest market cap and receives the highest weighting at about 5.8%. On the other end of the capitalization spectrum, News Corporation Class B (NWS) receives the smallest index weighting at less than 0.01%.
This weighting methodology creates a portfolio where only a tiny portion of the stocks have a meaningful impact on the index. The top 1% (or five stocks) of the index account for more than 18% of the movement of the S&P 500 Capitalization-Weighted Index (SPX).
The top 50% of stocks held in this S&P 500 index account for over 87% of the price movement of the index. Just 13% comes from the other 250 stocks in this index.
House of Representatives vs. Senate
The United States Congress provides a great example to help explain the capitalization versus equal-weighting concept to my clients. Specifically, I use the example of the House of Representatives.
The House of Representatives consists of 435 members. Each state receives seats in the House based on their population (like market capitalization).
Based on estimated 2019 numbers from census.gov, the United States population is 328 million. The most heavily populated state in the country is California with about 39.5 million people.
California receives 53 out of the 435 seats in the House of Representatives based on its population, giving California a 12.18% weighting. The next most populated state is Texas, which accounts for 36 seats in the House of Representatives and 8.28% of the vote. New York and Florida both have 27 seats for a 6.21% voting share.
On the other hand, states with smaller populations like Alaska, Vermont, Wyoming, and the Dakotas have only one seat in the House each. These seats amount to only just 0.23% of the vote!
In the United States Senate each state receives the same number of votes regardless of population. The Senate consists of 100 seats, two from each of the 50 states. Each of the 50 states receives a 2% weighting in the Senate. The Senate is equal-weighted.
The Other S&P 500 Index
Here is the key investment management point. The S&P 500 Capitalization-Weighted Index (SPX) is the House of Representatives. The stocks with the larger market capitalization receive the greatest weighting in the index.
The S&P 500 Equal-Weighted Index (SPXEWI) is the United States Senate. Each of the 500 stocks in the index are weighted equally.
Apple (AAPL) receives a 5.8% weighting based on its market cap in the “regular” S&P 500 Capitalization-Weighted Index (SPX). But in the S&P 500 Equal-Weighted Index (SPXEW) it receives the same equal weighting as every other stock at 0.20%.
Now let’s get to the long-term investment performance difference in these two stock market indices over the last 21 years.
Since the last day of December 1999, a $100,000 investment in the S&P 500 Capitalization-Weighted index (SPX) through March 18, 2021 would be worth $266,490.00 (excluding dividends and fees). That is an investment gain of 166.49%.
The same $100,000 invested in the S&P 500 Equal-Weighted Index (SPXEWI) over the same period would be worth $497,260.00 (excluding dividends and fees). That is an investment gain of 397.26%.
The S&P 500 Equal-Weighted Index (SPXEW) had an excess return of 230% compared to the S&P 500 Capitalization-Weighted Index (SPX) over the same time period.
The most important point. These indices are the same 500 stocks. The only difference is the weighting of those stocks in the index.
If your company 401(k) retirement plan account includes the SDBA (self-directed brokerage account) option, there are several ETF’s (exchanged traded funds) that own the S&P 500 Equal-Weighted Index (SPXEW).
The most popular S&P 500 Equal-Weighted Index (SPXEW) exchange traded fund I use in my client’s company 401(k) self-directed brokerage account is the Invesco S&P 500 Equal Weighted ETF (RSP).
Are you still invested in the S&P 500 Capitalization-Weighted Index (SPX) found on just about every company 401(k) mutual fund menu in America? If so, now you know how to own the same 500 stocks in your self-directed brokerage account to improve your long-term investment performance.
Ric Lager
Lager & Company, Inc.
