Returns Based on Market Construction

by Tyler Ellegard

There are several stock market indexes that we can use to determine how well U.S. stocks have performed, but the S&P 500 is one of the most popular measurements for the performance of U.S. large cap stocks. However, past performance of the S&P 500 may not be a perfect assessment of how the overall market is performing.  This is due to index construction and concentration differences that can significantly influence how indexes perform (especially in the short term). 

Stock market indexes can be structured in a variety of ways but the three most common are:

  • Market-cap weighted index (larger market caps have higher weightings)
  • Equally weighted index (all holdings are the same weight)
  • Price weighted index (weighted by price of the stock)

The S&P 500 Index is weighted by company market capitalization, meaning the larger the company, the greater the weight in the index. Currently, Apple Inc. (AAPL) holds a 7.1% weight in the index versus the smallest company in the S&P 500, Dish Network Corp (DISH), has a weight of 0.01%. Based on this structure, larger companies will have a greater impact on performance of the index. The table below shows the top 10 companies in the S&P 500 Index every five years dating back to 1980.1,2

The level of concentration, or the percentage of the entire index held by the top companies, is also important to understand and monitor.  Currently, the top 10 companies make up almost 30% of the entire index.  For context, the aggregate weight of the top 10 companies is equal to the bottom 394 companies in the S&P 500 index (28.8%).2

Analyzing index construction can provide greater insight into what is actually driving market performance.  A popular way of determining if a market rally is broad based or led by the larger companies is to compare the S&P 500 index versus its equally weighted version (where all 500 stocks have the same weight).  The table below shows the performance of the S&P 500 index and the equally weighted index.  Additionally, it shows the YTD performance of a few of the largest companies in the index.3

This data shows that, in 2022, the larger companies in the index significantly underperformed compared the overall S&P 500 index.  Because of this underperformance, the S&P 500 market weighted index underperformed the equally weighted index. Conversely, the opposite has occurred thus far in 2023.  Large companies in the S&P 500 have significantly outperformed, and as a result, the market weighted index is outperforming an equal weight version of the same stocks.  

Although there may be dispersions in performance from time to time, this trend tends to normalize.  As shown in the graph below, the market capitalization weighted S&P 500 performs inline with the equally weighted S&P 500 over longer periods of time.4

Lastly, it is important to know how the various market indexes are constructed as it will allow for a deeper understanding of what is driving the performance.  As an index, like the S&P 500, becomes more concentrated, the less diversified the returns will become.  This is not dissimilar to having a diversified plan for or in retirement.  Holding a diversified set of securities may not allow you to perform with the broader market on the upside, but will hopefully give you some protection on the downside and those sticking to that plan overtime will be rewarded.


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Posted on April 11, 2023
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