The S&P 500 index is one of the most widely followed indices in the world. As the index that tracks the largest 500 listed companies in the United States, it provides a comprehensive summary of the US stock market. Because it includes so many companies, the movement of anyone share or sector has a limited effect on the market. The index has existed in various forms since 1923, and its current form since 1957. The SPY ETF is the largest ETF that tracks the index.
What is an index?
Quite simply, an index is a statistic that tracks the prices of a basket of shares. Most indices, including the S&P 500 and the Nasdaq 100, are weighted by market capitalization. This means each company’s shares price is weighted by the total market value of that company, as a percentage of the sum of the value of all the companies in the index.
As an example, if a company has a market capitalization of $5 billion, and all the companies in the index are together worth $50 billion, then that company would have a weighting of 10 percent in that index. If that share rises two percent on a given day, then that will contribute to a 0.2 percent rise in the index (10% x 2%). On a given day the index will rise or fall by the sum of the weighted percentages moves of all the constituent companies.
Some indices, most notably the Dow Jones industrial average, are weighted by price. A price-weighted index is calculated by simply adding up the prices of all the constituent companies. Fundamentally weighted indices are weighted by fundamental factors such as revenue or number of employees. And some indices are equally weighted, in which case every share has an equal weighting in the index, regardless of the market cap.
Constituents of the S&P500 Index
The largest company in the S&P500 index as of April 2017 was Apple with a weighting of 3.6%. Apple was followed by Microsoft at 2.5% and Amazon at 1.8%. By contrast, the smallest 50 companies in the index make up just 1.3%. In fact, 50 companies account for half of the index, with the other 450 companies making up the other 50%. The performance of an index like the S&P500 is heavily weighted toward the performance of the largest constituent companies.
The S&P500 index is one of the most important benchmarks in investment markets. It’s used as a benchmark for mutual funds, and as a result, derivatives that are based on it trade in high volumes. If lots of investors and traders trade in a market, liquidity increases and the bid-offer spread comes down. That makes instruments based on it some of the cheapest to trade and manage.
Rebalancing
The S&P500 index is rebalanced every quarter. If new companies have entered the top 500 by market cap, they will be added to the index and those that fall out of the top 500 will be deleted. ETF issuers will, therefore, have to adjust their holdings, but these shares are only a tiny fraction of the index, so the impact is minimal. If companies buy back shares or issue new share, the funds will also have to adjust their holdings.
SPDR S&P 500 ETF
Index funds have been around since 1973, but originally took the form of mutual funds that tracked an index. The SPDR SPY was the first exchange-traded fund and was listed on the American Stock Exchange in January 1993. Besides being the oldest, it’s also the largest and most actively traded ETF in the world with assets under management of $212 billion dollars.
The iShares S&P500 ETF has $103 billion under management, and the Vanguard S&P500 index has $63 billion.
The ETF is managed by State Street SPDR. The acronym SPDR comes from Standard and Poor’s Depositary Receipts, the original name of the ETF. The share code is SPY, and they are known as ‘spys’ as SPDR came to be pronounced ‘spyder.’
The SPDR ETF has 25% exposure to the tech sector (which includes 3 of the 5 largest companies in the index) and 14% exposure to the financial sector. These are followed by healthcare, consumer discretionary and industrial stocks.
The chart below plots the SPY ETF against the S&P500 index. The difference between the two is caused by the costs and the tracking error. It is occasionally possible for an ETF to outperform the index it tracks – this is achieved earning fees by lending shares in the fund to hedge funds.
The expense ratio is 0.09%, and the average bid-ask spread is 0.02% which is very low.
The S&P500 is an ideal ETF to use as a core holding in a portfolio. It may well form the largest component and be held for the longest, while at the same time being the cheapest holding to own. The SPY ETF can be complimented with sector SPDR funds to increase the weighting of specific sectors, or with small cap, international or emerging market funds to enhance the return. A popular strategy is to maintain a core holding in SPY and compliment it with a rotational strategy moving into the sectors with the highest momentum.