The S&P 500 Index measures the stock performance of 500 large companies listed on U.S. stock exchanges. It is not a fund that investors can put their money in. However, portfolio management companies offer funds that replicate the index. They are called S&P 500 index funds. Below, we will discuss how portfolio managers and asset management companies invest in the S&P 500 Index.
The S&P 500 index, or Standard & Poor’s 500, is a very important index that tracks the performance of the stocks of 500 large-cap companies in the U.S.
Since investors cannot invest in the index directly; portfolio managing companies offer funds that replicate the index called S&P index funds.
Portfolio managers and asset management companies broadly use two strategies to replicate the index: Exact Replication and Sampling.
What is the S&P 500 Index?
The S&P 500 Index, or Standard & Poor’s 500, is a commonly followed index that tracks the performance of the stocks of 500 large-cap companies in the U.S. The index is considered to be a good representative of the U.S. stock market. It includes 500 stocks of companies from different sectors, thereby making it more diverse than the Dow Jones Industrial Average (DJIA), which comprises 30 stocks, or the NASDAQ Composite, which tracks 100 stocks.
Moreover, the index includes companies representing a particular sector in the same proportion of the sector in the stock market. For example, if pharmaceutical companies represent 5% of the US large-cap market, the companies will represent 5% of the market cap of the S&P index, too. Therefore, the makeup of the S&P 500 Index reflects the constitution of the economy as well.
Investing in the S&P 500 Index
Portfolio managers and asset management companies broadly use the following two strategies to replicate the index:
1. Exact Replication
The above strategy requires an index fund to hold all the 500 stocks in the exact proportion as their weightage in the index. The weight assigned to each stock is equal to the share of its market cap in the total market cap of the index. Assume stocks A, B, and C constitute the index. The following information is available about the stocks:
A fund representing the index must include the stocks above, with the total value of the portfolio divided among them in the ratio 5:3:2.
Though the process looks simple, making an index of 500 stocks is much more difficult. Moreover, the weights must constantly be changed in the index with any fluctuations in the market price of shares or changes in the number of shares available for public trading.
The continuous entry and exit of companies must also be accounted for, which makes the process extremely tedious. Exact replicas of the original index come with high administrative costs since it must include the shares of 500 companies.
Index funds constructed using the sampling strategy will include a subset of the stocks in the S&P 500. However, the subset is created after dividing the stocks into several categories and running optimization exercises to determine which of them best represent the index. It generally includes companies with the highest market capitalization.
The sampling strategy saves cost, but it also leads to greater deviation from the performance of the actual index.
Advantages of Investing in S&P 500 Index Funds
Investment in S&P 500 index funds provides the following advantages:
1. Passive management
Investors holding S&P 500 index funds try to match the performance of the index, not to outperform it. Therefore, they can use the buy-and-hold strategy of investment, also known as passive management. There is no need to actively monitor the stock market movements and engage in intense intra-day trading. Even inexperienced investors can earn high returns by investing in the index funds.
Since the index funds represent all sectors of the U.S. stock market, they are diversified investments with relatively low market risk. Moreover, the high number of constituents of the S&P 500 further reduce exposure to market risk.
Disadvantages of Investing in S&P 500 Index Funds
Despite the advantages mentioned above, the S&P 500 index funds also come with certain disadvantages, which are as follows:
1. Ambiguity about the divisor
The S&P does not disclose how it calculates the value of the divisor. Since the divisor is meant to account for and moderate the effects of all changes that affect the value of the index, any miscalculation or misrepresentation in such respect threatens the authenticity of the index.
2. Narrow focus
The S&P 500 index does not include the stocks of foreign companies. Therefore, it is not a good representative of the global financial market. Moreover, it does not include bonds and commodities, which are important determinants of the state of financial markets and economies.
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