The Standard and Poorâs brand is so ubiquitous that itâs easy to forget some of the basics.
The ratings arm of the company made good on its threat to lower the rating of U.S. sovereign debt, and it made that judgment using a committee of experts. Using a team approach rather than a rules-based method for this momentous decision is appropriate given the breadth and depth of the U.S. economy.
A committee at S&P is also charged with index construction. This group of people ultimately decides which stocks are present in the S&P 500.
This strikes me as odd. After all, a pure market-cap weighted index should reflect, well, the market. That is, it should represent a weighted average of the market value of equity for U.S. companies, based on transparent rules and without human intervention.
The S&P 500 intentionally differs from pure market-cap indexes. In addition to the obvious goal of representing large-cap equities, it also aims to reflect the U.S. equity market as a whole.
To achieve its goals, the S&P index committee considers factors beyond market value of equity when adding stocks. For example, it performs fundamental analysis and considers sector representation when evaluating potential additions to the index. These screens are at odds with pure market-cap selection.
From a practical standpoint, the S&P 500âs holdings also differ in rank from other market-cap indexes. Take a look at two popular ETFs as index proxies:the iShares S&P 500 Index Fund (NYSEArca:IVV) and another broad large-cap fund, the iShares Russell 1000 Index Fund (NYSEArca:IWB).
Are these differences huge? No. But theyâre more than youâd expect among supposedly vanilla large cap equities.
All large-cap indexes â even the ones Iâd call pure market-cap weighted â vary considerably in their holdings. These differences are driven mostly by the rules that define their market-cap buckets.
Indexes make an adjustment for liquidity and free-float. Then they rank the firms from largest to smallest, with Exxon Mobil at the top, and down the list from there.
At this point, methods diverge. MSCI and Russell for example, define large cap by rank, selecting the top 300 and 1000 respectively. Dow Jones U.S. and FTSE USA draw the line by percentage, adding the companies from the largest on down until each index sums to 70 percent of total U.S. equity market value.
Because of these differences in methodology, direct comparison to the S&P 500 is difficult. Iâll leave it to the academics to sort out whether the S&P 500âs committee-based selection or its 500 stock universe is a bigger driver of risk and return.
My point here is simply to remind everyone what they probably already know â or knew once but forgot: the S&P 500 deviates from pure market representation. If you define extra risk as variance from the market, then this famous index has a bit of it.
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