The major US, and well world indexes, for that matter, are all market capitalization-weighted indexes. This means the index will own a particular amount of one company or another based on that company’s market cap. On the surface, this sounds fine. And decades ago, when the indexes were really starting, this method worked just fine. It was a fast, easy, and simple way for investors and money managers to put together the index.
But fast forward to today and beyond, and market cap indexes may not be the best solution due to the simple issue of the index being too heavily weighted. In a past article, I highlighted how the top 5 companies in the S&P 500 represented 23% of the index. That means 5 companies represent almost a quarter of what an index that supposedly tracks 500 companies is doing.
However, over the past few years, especially the past year, these top five companies, Apple (AAPL), Microsoft (MSFT), Amazon.com (AMZN), Facebook (FB), and Alphabet (GOOG), have performed incredibly well. So, investors who have ridden these market-cap-weighted indexes higher for a few years are very happy and have done very well.
However, there is always a downside risk, and with these market-cap-weighted indexes being so heavily weighted to the top 5 or 10 stocks, the risk is much higher than most investors fully understand.
The idea of investing in an index fund or mutual fund is to diversify your assets and, therefore, lower your risk to single stock issues. However, since these market-cap-weighted indexes are so heavily weighted to the large technology companies, investors, in some senses, are very much at risk of having single stock issues. For example, what happens if Apple, the largest company in the S&P 500, which represents 6.22% of the index, has a few issues with iPhones, and the company starts to fall out of favor. Or what if Amazon, Facebook, and Google all get hit with anti-trust lawsuits and have to split or cut parts of their current business? Those three companies are the third, fourth, and fifth largest holdings in these market-cap-weighted indexes, making up 10.63% of the S&P 500 index.
Apple making a mistake or falling behind the competition may seem like something that would never happen, but people used to think that way about Blackberry. As for the anti-trust regulations, well, we already saw Microsoft, the second-largest company in the S&P 500, go through an anti-trust 20 years ago, and oh, by the way, a lot of politicians in Washington have been talking about how these technology companies are getting too large and powerful. So, to think government-related issues aren’t coming down the pipeline for some of the top names in the index may be foolish.
We also know, from history, that the largest companies of today, in terms of market cap, will not likely be the top companies in the future. (While yes, one could make the argument that Microsoft has been a top company for more than 20 years now, I am referring to the norms, not the one-off situations.) Furthermore, a lot of companies that were dominant players over ‘long’ periods of time not only don’t perform as well but sometimes go under completely.
If we look at the S&P 500 today, only 2 of the top 10 companies in the index even existed 35 years ago. And while JPMorgan Chase, the tenth-largest company in the S&P 500, has been around for more than 100 years, it just re-entered into the top 10 list in the past few months.
The point of all of this is that you may want to start considering looking at Exchange Traded Funds that don’t particularly point so much weight on just a few stocks. For example, look at Non-Market Cap Weighted ETF’s that start each quarter, month, or even year, with a level playing field, and all the stocks in the index represent the same about of the fund.
Something like the Invesco S&P 500 Equal Weight ETF (RSP) or the First-Trust Nasdaq-100 Equal Weighted Index Fund (QQEW), or even a specialty ETF like the SPDR S&P Biotech ETF (XBI). These ETFs don’t balance their holdings based on market cap; they are balanced based on many holdings and other factors. Which, in turn, will dramatically lower the risks typically found with the market-cap-weighted indexes.
INO.com Contributor - ETFs
Follow me on Twitter @mthalman5513
Disclosure: This contributor owned shares of Apple, Amazon, Microsoft, and Alphabet at the time this blog post was published. This article is the opinion of the contributor themselves. The above is a matter of opinion provided for general information purposes only and is not intended as investment advice. This contributor is not receiving compensation (other than from INO.com) for their opinion.