What is "the market?"
Updated: Jan 5
By Michael Mooney CFP ®, Financial Advisor
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The investment community has become accustomed to considering the results of the S&P 500 index as that of the overall markets. When you listen to the evening news, the index is often highlighted as a measure of market movement.
While there are periods in which the S&P 500 closely resembles the performance of the overall markets, there are also times in which there can be a large disparity. This has largely been the case over the past few years, and 2020 is no different. Recently, there has been a large variance between the S&P 500 index and the majority of the individual companies that make up the index. Since the index is weighted, larger companies at the top have more performance ‘pull’ than companies at the bottom. When those larger companies outperform, the results of the index may not be entirely indicative of the market as a whole.
While many investors use the S&P to measure success of a portfolio, we review a variety of different indexes.
How are market indices calculated?
There are three common ways that indexes (such as the S&P 500) are calculated – Market Weighted, Price Weighted, or Equal Weighted:
Market weighted: A Market Weighted Index gives more weight to companies with a higher Market Capitalization or company value. A company with a $500 billion total value will sway this index more than a company with a $100 billion total value. The S&P 500 is an example of a Market Weighted index.
Price weighted: A Price Weighted Index gives the most weight to companies with the largest share price. This is independent of their Market Capitalization, and only depends on the dollar amount of a stock’s trading price. In this index, a company with a $300/share price has more effect on the index than one trading at $50/share. The Dow Jones Industrial Index is an example of a Price Weighted index.
Equal weighted: An Equal Weighted Index gives equal weight to all companies in the index. If there are 20 companies in an index, each would account for exactly 5% of the index, regardless of Market Capitalization or share price.
WHAT IS THE S&P 500?
The S&P 500 is an index that tells us the average return of the companies that are included in it, which are 500 large U.S. companies. It is a market-weighted average, which means that not all 500 companies have the same impact. For example, two companies in the index could each have a +10% return; one of them could have a very big impact on the index, while the other’s impact is minimal. We have seen this in 2020 with several names having a very disproportionate impact on the index.
HOW DOES MY ASCEND ADVISORY PORTFOLIO COMPARE TO THE S&P 500?
While the S&P 500 is often referred to as ‘the market’, it is really just a subsector of just one type of asset. Conversely, you may recall conversations and communications about the “bucket” strategy (allocation) that we ascribe to in our portfolios. Every Ascend Advisory Group built portfolio has three buckets of assets:
Fixed Income (Bonds)
In a very boutique, client-by-client fashion we determine what allocation each of these 3 buckets should have. In comparison to the S&P 500, we have to consider that the S&P 500 is 100% equites with no allocation toward cash or bonds. This means there is no allocation to buckets #1 and #2. Even within equities, the S&P 500 is a weighted average of only Large Cap U.S. companies, while your equity exposure includes companies of all sizes (Small Cap, Mid-Cap, and Large Cap) as well as International equities.
There are other indexes that represent different sections of the investment market. Here are some of the more notable ones that you may hear about:
S&P equal weighted index: Using the same 500 stocks as the S&P 500, this index equally weights each of the companies. With this method, each stock accounts for exactly 0.2% of the index. A company that has a 5% return and a $100 billion market cap will have the same effect on the index as a company with a 5% return and a $900 billion market cap.
Dow Jones Industrial Index (“THE DOW”): The Dow is an index that measures performance of 30 large and respected publicly owned companies on the New York Stock Exchange and NASDAQ. Unlike the S&P 500 which is market cap weighted, the Dow is a price weighted average, meaning that stocks on the index with a larger share price have more weight.
NASDAQ Composite Index: The NASDAQ measures all of the companies listed on the NASDAQ stock exchange (over 3,000 total stocks). Many of the stocks listed on the NASDAQ are within the technology sector, although the index also includes other sectors as well. Similar to the S&P, the NASDAQ is market weighted.
Russell 3000 Index: The Russell 3000 measures 3,000 of the largest US traded stocks by market capitalization. It is a market-weighted index.
Russell 2000 Index: The Russell 2000 is an index that is often used as a benchmark for Small Cap stocks. It measures the smaller of the 2,000 companies within the Russell 3000 Index. It is also a market-weighted index.
MSCI Eafe Index: Unlike the aforementioned indexes, the EAFE Index measures the stock performances of companies outside the US. This index includes a group of stocks from 21 developed countries, not including the US. The stocks within this index are predominantly located in Europe, as well as Australia, Asia, and the Middle East. It is a market-weighted index.
MSCI Emerging Markets Index: This index is used to measure the equity performance of global emerging markets across the globe. It includes companies from about two dozen countries. It is a market-weighted index.
Barclays Capital Aggregate Bond Index: The BarCap Agg index is the only index mentioned above that does not track stocks. It measures the performance of about $15 Trillion worth of bonds. It includes almost all investment grade bonds within the US and it is market weighted.
WHICH INDEX SHOULD I USE TO COMPARE TO MY ACCOUNT?
If your account was invested in 100% Large Cap U.S. Equities, then either the S&P 500 or the S&P 500 Equal Weighted Index. However, as we previously mentioned, your portfolio includes bonds, cash, and a variety of different types of stocks. Thus, there is no one index that can be used to compare to your account.
When we review the performance and success of the account, we use several of the indexes listed above. We can compare your Large Cap Equities to the performance of the S&P 500, your Small Cap Equities to the performance of the Russell 2000, your bonds to the BarCap Agg Index, etc.
In 2020, we have seen quite a diversion among stocks. The largest of the Large Capitalization companies have performed admirably, which has driven up the S&P 500 (market-weighted) Index. However, the majority of Large Cap stocks have not performed nearly as well, causing the S&P 500 to have a large advantage over the Equal-Weighted version of the index. Similarly, Small Cap and International equities have also lagged.
Wells Fargo Advisors Financial Network did not assist in the preparation of this report, and its accuracy and completeness are not guaranteed. The report herein is not a complete analysis of every material fact in respect to any company, industry or security. The opinions expressed here reflect the judgment of the author as of the date of the report and are subject to change without notice. Any market prices are only indications of market values and are subject to change. The material has been prepared or is distributed solely for information purposes and is not a solicitation or an offer to buy any security or instrument or to participate in any trading strategy. Additional information is available upon request.
Past performance is no guarantee of future results.
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