The S&P 500 Index started off as a noble idea. It was supposed to be a way to track the change in value of the US stock market, as represented by its 500 largest companies (with a few caveats). It’s also gotten a little extra attention lately, since it recently surpassed 5,000 for the first time. Big round numbers have a way of doing that.
It has also become the benchmark by which most all other strategies which invest in large US-based companies are measured against. Most everyone who has any investing experience by now knows that they can buy a fund which is designed to track this particular index, with minimal expenses associated with it, and indeed most 401k participants now have this option available to them in their plan.
The thing that I can’t help but notice about the index today is how amazingly top-heavy it has become. I pulled the following off of the etf.com website today (Feb 13) listing the top components of a very popular fund that is designed to track the S&P 500:
Holding Allocation %
- Microsoft Corporation 7.40%
- Apple Inc. 6.54%
- NVIDIA Corporation 4.22%
- Amazon.com, Inc. 3.76%
- Meta Platforms Inc Class A 2.46%
- Alphabet Inc. Class A 2.09%
- Alphabet Inc. Class C 1.77%
- Berkshire Hathaway Inc. Class B 1.72%
- Eli Lilly and Company 1.40%
- Broadcom Inc. 1.33%
Please note that both classes of Alphabet (aka Google) are listed, so this is really a list of the largest nine holdings in S&P 500 index funds.
Add it up and it’s 32.69% in just nine companies, and this is supposed to be representative of the US stock market. So almost 1/3 of all money that flows into S&P 500 index funds end up invested in just nine companies, while the other 491 components of the index get the other 2/3.
How did this come to be? The answer lies in the fact that the index is capitalization weighted. All that means is that once a stock is included in the index, its weight in the index, and by extension the influence its price has on that index each day, is strictly a function of its total market value.
In principle, this seems reasonable. Larger companies should have a larger influence on an index that is supposed to be representative of “the market.” It would not be reasonable to argue that Microsoft and Intuit should have the same or even similar weights in the index when Microsoft brings in about 15x as much revenue as Intuit each year. But strictly calculating the weights on total market capitalization alone leads to some pernicious effects once the strategy becomes really popular, as you will see.
The primary problem I alluded to above – the more valuable a company becomes, the more money it will attract to its shares when people buy index funds en masse. In case you haven’t heard by now, index funds have become really, really popular! In fact, most estimates are that roughly half of all money invested in the US stock market is now done through these passive index funds. And if we were to look at just the flow of new money into the market, on a net basis, virtually all of it is flowing in through these funds.
Index funds were invented on the idea that there were lots of investors and analysts doing the hard work of figuring out what companies are actually worth, comparing that conclusion to the current market price, and deciding to either buy or sell the shares on that basis. That is the whole essence of the Efficient Market Hypothesis – that the market already reflects all available information, so therefore it’s impossible to get an edge, so therefore you should just go along for the ride and minimize your costs as much as possible.
That seems reasonable when passive indexing strategies represent a modest portion of the market, because the prices being set in the market for each company are still grounded in fundamentals, the analysis which takes place around fundamentals, and individual buy/sell decisions of investors.
But now that these passive, market capitalization strategies completely dominate the flow of new money into the market, we have a situation where the indexing is no longer the price taker, but instead is the price maker. The prices are being set according to a formula that simply says “bigger is better.”
It gets worse. Regulations around employer-sponsored retirement plans have created tremendous incentive to focus on minimizing costs and offering low-cost index funds, and the target date funds which feed into them, as the primary option on the menu for employees in their 401k plans.
So we have managed to construct a system where virtually all the new money that is going into the market is being allocated not on the basis of relative value, but on the basis of price, and the higher the price, the more money we plow into those high-priced stocks. The more overvalued a company becomes, the more demand there will be for their shares as working Americans continue to robotically add to their 401k plans. We are systematically rewarding both large size and momentum at the expense of all other investment considerations. That is why the index is so top heavy.
Now put yourself in the shoes of an active money manager – one that is still trying to do the work, figure out what companies are actually worth, and invest in those that seem attractively priced and avoid those that don’t. And remember, their work was the foundational logic behind indexing to begin with. And let’s suppose for sake of illustration that, despite its obviously impressive qualities, you have your doubts that Microsoft is actually with $3 trillion.
You say to yourself, “Gee, for $3 trillion, you could buy all of the farmland in the United States! Or all of the commercial office buildings in the country…..or all of the companies in the S&P Energy Sector, twice over!” And you correctly note to yourself that, despite the fact it carries only half the value of Microsoft, and therefore attracts only half the dollars Microsoft does for its shares when new money is put into these index funds, the S&P Energy Sector generates twice as much free cash flow as Microsoft.
Maybe you try to put together a spreadsheet that models forward projected sales and earnings and realize that at over 13x revenues and 37x earnings, it’s tough to make the math work out for a payback period on a company that already does $225 billion in annual sales. After all, 20% growth would represent $45 billion in new sales next year.
Now ask yourself, as that active manager, do you dare avoid buying Microsoft? After all, it’s over 7 percent of the benchmark. If, despite your misgivings about valuation, you hold your nose and invest a full 5 percent of your fund into Microsoft, you are still underweight relative to your benchmark. That is the reality that money managers face today. To not own Microsoft in tremendous size would be radical and risky.
So even though there are still a lot of actively-managed strategies out there, they all end up largely buying the same few stocks as the index funds, because if they don’t, they risk underperforming their benchmark, which means their fund will lose assets, and they may lose their jobs. It’s a lot easier to go along with the crowd, they think. All this does is serve to reinforce the dynamics at work with index funds.
So given all of that, how much of the demand for the shares of Microsoft, Apple, Nvidia, etc. are actually being shaped by investors who are doing the work, coming to the conclusion that the shares are fundamentally undervalued, and therefore deserve to be bought to the exclusion of all other possibilities? I would submit that it is very, very little.
Given the reality of this, and the fact that it seems unlikely to change anytime soon, I would expect to see the following unfold, with great uncertainty around the timing:
Large companies are likely to continue to outperform the rest of the market, due to the dynamics outlined above.
US companies are likely to continue to outperform the rest of the world, for the same reasons.
These mega-cap US stocks will continue to become more and more stretched (expensive) relative to their fundamentals.
Eventually (probably when the passive flow stops or goes into reverse), this will all unwind in spectacular fashion. And the longer it continues, the more spectacular it will likely be.
Index funds based on this methodology, and systematically popularizing them, may be the closest thing to a perpetual motion machine that we have ever created. They were also intended to be a way of saving money, just like the Russians’ “Doomsday Machine” from the movie alluded to in the title of this article. I think what we are seeing here is a dramatic illustration of the law of unintended consequences playing out before our very eyes.
Any opinions are those of Accordant Advisory Group and David McKee and not necessarily those of RJFS or Raymond James. Expressions of opinion are as of this date and are subject to change without notice. The information provided does not purport to be a comprehensive description of securities, markets, or other developments. This information had been obtained from sources considered reliable, but we do not guarantee that the foregoing material is accurate or complete. Any information provided is not a complete summary or statement of all available data necessary for making an investment decision, nor does it constitute a recommendation. Investing involves risk and investors may incur a profit or loss. Every investor’s situation is unique and you should consider your investment goals, risk tolerance and time horizon before making any investment. The S&P 500 is an unmanaged index of 500 widely held stocks that is generally considered representative of the U.S. stock market. Prior to making an investment decision, please consult with your financial advisor about your individual situation.