The Standard & Poor’s 500 Index is market-capitalization weighted, meaning that companies with higher stock-market valuations have a bigger influence on the index. There has been a cottage industry of criticism about this structure. Recently, it has led to a new world of fundamental indexing and so-called smart beta, or seeking ways of using the components of the index to outperform the index itself.
The S&P 500 wasn’t always set up this way. This is a good time to think about the subject, because today marks the anniversary of the index’s overhaul, giving us the structure we have now.
According to the S&P 500 2001 Directory (hat tip to Jason Zweig’s This Day in Financial History), the benchmark index for large cap U.S. stocks looked very different than it did before this day in 1988.
Back then the index was made up of:
400 industrial stocks
This seems like it was an effort to mimic Dow Jones, which had three big indexes — the Industrial Average, the Transportation Average and the Utilities Average. According to the Dow Jones Industrial Average Fact Sheet, the Industrial Average was designed “to represent large and well-known U.S. companies, cover[ing] all industries with the exception of Transportation and Utilities.” Having been around since the late-19th century, it had become the benchmark for measuring the U.S. stock market.
Here’s what the S&P 500 looks like today:
The shift toward a broader, market-cap-weighted index was designed to avoid some of the fundamental flaws in the Industrial Average, which is price weighted, meaning companies with higher stock prices have greater influence. This leads to all manner of absurdities, as we have discussed before:
Companies with higher stock prices such as Visa and Goldman Sachs have a 9.7% and 6.7% weight, respectively, while lower-priced stocks, such as Cisco Systems and General Electric, are merely 1.05% and 0.91%, respectively. Why Goldman Sachs, with an $84 billion capitalization, matters more to the Dow than General Electric, with a $257 billion capitalization, is rather mystifying. A high-priced, smaller company carrying more weight than a lower-priced, bigger company makes no sense.
Shifting from price-weighted indexes to market cap-weighted indexes was a huge improvement, but it wasn’t without its own problems.