What's in an index?

Markus Muhs - May 20, 2020
And why is the S&P 500 performing so well???

I tweeted the following last week after pondering the top 5 S&P 500 constituents and how resilient those particular companies have been through the Covid-19 pandemic, which now make up over 20% of the index combined

The S&P 500 is probably one of the more balanced indices out there in terms of being fairly diversified across different industry sectors and not too overweight in any one of them. It’s a tad tech heavy, but that overweight has served investors well over the past decade and the past 3 months especially.

As the FAANG stocks became more and more “overvalued” though in the years leading up to the end of the last decade, and became a bigger part of the index, it became harder and harder for active managers—who typically underweight these fundamentally overvalued companies—to outperform. Something has to give! The pandemic and ensuing market crash just hit active managers over the head with a two-by-four: cheap, high quality stocks got obliterated—and have only somewhat recovered—while those overvalued, “risky” growth stocks either weren’t phased by the pandemic or else have now fully recovered and are approaching new highs. 

Tech’s outperformance makes sense too, unlike the 1999/2000 tech bubble. The tech companies of today continue to make money hand over fist, unhindered by the pandemic, continuing to provide vital services or shipping goods to consumers. Meanwhile, companies in more traditional sectors are paralyzed by shut downs and quarantines.

Sidenote: any and all companies and ETFs listed in the following are examples only and not to be construed as recommendations. I recommend owning a diversified mix of index funds in the core of your long-term portfolio, as suitable for your risk and objectives, but I generally do not recommend owning individual stocks. Consult an investment professional or do your own due diligence before investing.

If we look at the S&P top-20, it’s almost a perfect pandemic portfolio, with a bit of diversification. The rankings and approximate weightings are as follows, based on the daily holdings of the SPY ETF as of May 15th:

Microsoft 5.9% Technology
Apple 5.4% Technology
Amazon 4.2% Consumer Discr, largely tech
Alphabet 3.5% Communications, largely tech
Facebook 2.1% Communications, largely tech
Johnson & Johnson 1.7% Healthcare
Berkshire Hathaway 1.4% Financial, plus other things
Visa 1.3% Technology (did you know that?)
Procter & Gamble 1.2% Consumer staples
United Health 1.2% Healthcare
JPMorgan Chase 1.1% Financial
Home Depot  1.1% Consumer Discr
Intel 1.1% Technology
Mastercard 1.0% Technology
Verizon 1.0% Communications
Pfizer 0.9% Healthcare
nVidia 0.9% Technology
AT&T 0.9% Communications
Merck 0.9% Healthcare
Netflix 0.8% Communication

 

In total these companies make up almost 40% of the index, while another 480 or so companies make up the the other 60%. The largest have market capitalizations of around $1.4 trillion, while the smallest are around $200 billion. 

All in all, if you consider the types of companies that did well over the past 3 months, leading the index you have:

  • More than half the above weightings are in largely technology companies that benefit from work-from-home office upgrades (Microsoft, Apple, Intel), vital cloud computing (Microsoft, Amazon, Intel), online shopping (Amazon), and more shut in people videogaming (nVidia) or streaming Tiger King (Netflix, which is up around 40% year to date). The tech sector, by measure of the ETF XLK, is up 2% year to date, the day I write this.
  • Healthcare companies, vital during a health pandemic and attracting a lot of spending, make up around 12% of the above. A little further past the top-20 you’ll find a few names in the news, including Covid-testing device makers Abbott Labs at 0.7%, Thermo Fisher Scientific at 0.6%, and anti-viral drug developer Gilead at 0.4%. Healthcare stocks, by measure of XLV, are down only 1.4% year to date.
  • Beyond that you’ve got a few other highly important stocks during this era of self-isolation. Facebook (up 3% YTD) has become crucial for social interaction via their namesake social media app, and Instagram. Their Oculus VR headsets may have gained traction as people spend more time at home videogaming, and WhatsApp is more crucial than ever for people around the world to stay connected (it even added Zoom-like video-conferencing features).
  • Rounding out the top 20, a couple of other very useful companies in the cash-free retail economy (because who wants to exchange pieces of paper, metal, or polymer that other people have touched anymore?), “technology” companies Visa and Mastercard are making their 1.5% or so on every transaction we do, from Amazon purchases to paying our Netflix subscriptions. Add to that a consumer staple, in P&G, that makes a lot of the things we’re hoarding, like toilet paper, or buying anyway regardless of whether there’s a pandemic or recession. Home Depot too continues to do well, perhaps with people doing more home repairs, up almost 10% year to date.


Meanwhile, the absolute worst performing sectors in the U.S. year to date are:

  • Energy, down 40%, not represented by any company in the top-20, and a paltry 3% of the overall index.
  • Financials, down 32%. Berkshire Hathaway is classified as a “financial” because of its large insurance business, though it contains industrials, consumer staples, and more. JPM is the only bank in the top-20. Excluding BRK, the financial sector is less than 12% of the index.
  • Industrials, down 27%, are non-existent in the top-20 and only 9% of the index.
  • Real Estate, down 20%, is 4% of the index
  • Materials, down 17%, are 2% of the index

 

Industry allocations within the S&P 500 have varied greatly over time, as demonstrated each year in Credit Suisse’s Investment Returns Yearbook where at the bottom of page 21 you can see the difference between sector allocations in 1900 (looks like 65% railways!) and 2020 (much more diversified, mostly in industries which didn’t exist in 1900). In a way, the drift in allocations is to the investor's benefit; those industries that fall out of favor become smaller and inconsequential while new growing industries become a bigger and bigger slice of the pie; you never have to worry about being excluded from the new trends. 

Just imagine if you could invest for 120 years and decided from 1900 onward you’d keep rebalancing your portfolio to stay around 50% railways and maybe only taking 5% bites along the way out of the new technology, healthcare, and telecom industries. Your performance would likely have been much worse than going with a purely capitalization-weighted portfolio that allowed its weightings to drift with the value of its constituent companies. This post by Visual Capitalist shows how much the leading companies in the index have changed, even over just the past few decades. Imagine if you simply held the biggest companies from 2004 and kept weighting them as the largest companies in your portfolio: General Electric (down 80%), Exxon Mobil (down 50%), Microsoft, Pfizer, Citi (down 90%), etc.  

What about the rest of the world?

For most of the past decade we’ve seen U.S. stocks beat the pants off of everyone else; notably the other developed markets (primarily Europe and Japan) and especially Canada. Part of it is economics, with the U.S. economy having had a bit more success, but a lot of it has to do with the contents of each index. Most of the large companies of the world do business globally anyway, so have global companies based in the U.S. really done much better than global companies based in Europe? Not really, when you compare apples to apples.


Source: Morningstar Advisor Workstation, April 30 2010 to April 30 2020, starting with $1000, adjusted to CAD

Getting back to the title of the post; what’s in an index? Well, what’s in the international developed market index is quite a bit different from what’s in the S&P 500 as we can see below, based on the contents of the ETF VEA:

Though it looks a little more diversified (more evenly sized pie slices) than the S&P 500, it's a little less attractive of a mix of industries going into the Covid pandemic. The top holdings in the international index at least includes some pharma names like AstraZeneca and Novartis, along with technology companies ASML and SAP, but looking a little farther down the list are (or at least were before their prices dropped) a bunch of banks, industrials, more traditional industries.

Worse is when you look at the Canadian index. If it weren’t for Shopify and gold miners, this index would be the absolute worst you could have positioned your portfolio going into the pandemic. Year to date, TSX Financials are down 25%, energy companies are down almost 50%, and though Materials (largely gold miners) have done great of late, that sector is down over the past decade.

I think ultimately what can be gleaned from comparing these three indices is that when you’re investing in each, or diversifying your portfolio between the three as is commonly done, you’re not really diversifying yourself between the U.S. economy, Europe, Japan, and Canada. Usually when there’s a recession it affects all countries; what ends up happening though is that during a weaker year like 2015 you get poor performance out of your commodity and bank-heavy Canadian fund, while global equities do okay. When oil recovered in 2016 you then ended up with an outperforming Canadian fund. This had nothing to do with the Canadian economy doing that much better.

When you combine all three you actually do get a pretty well diversified, well-balanced portfolio. The massive financials-overweight in the Canadian portfolio is diluted away, as is (unfortunately, when looking at the very recent past) the technology overweight in the U.S. Further, if the technology sector does continue to become a larger piece of the pie globally (in Canada alone, the fact that it's now at 9% is largely attributed to Shopify's growth) then we'll find a larger and larger allocation to it in our index portfolios. 10 years from now, the largest companies in the world might be completely different, and our index portfolios will hold those 10 companies as our largest holdings, while active funds or individual stock pickers might not.

 

Markus Muhs, CFP, CIM