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What’s in Your Index?

December 24, 2020 By Cardinal Point Wealth

It is estimated that over $11 trillion USD is indexed or benchmarked to the S&P 500 index, or what many investors consider ‘the market.’ However, while that index does capture a good chunk of the public stock market capitalization in the U.S., it omits the rest of the globe. The criteria by which companies are included—which involve a secret selection committee and very general guidelines—are also somewhat murky.

Most recently, the S&P 500 index made news in this regard when it was decided that Tesla would finally be included beginning December 21, 2020. As a market capitalization weighted index, in which the largest companies represent the largest allocations, this was newsworthy because of Tesla’s meteoric rise over recent years. By market capitalization it is now somewhere around the fifth or sixth largest publicly traded company, larger than the likes of JP Morgan, Visa, Home Depot, and Johnson& Johnson.

Some have argued it does not always make sense to hold the largest weights in companies which are already the largest size, but research has also shown it has been a tough index to beat, especially as giant growth-oriented names have dominated performance over recent years. Currently the index is relatively concentrated at the top compared to previous years. In fact, the top five names of Apple, Microsoft, Amazon, Google, and Facebook represent 22% of the index. And each of those companies has done very well in 2020, with an average gain of 48% through Dec 12.

While the index does capture the majority of broad U.S. market stock exposure as measured by stock market capitalization, it lacks many medium and smaller listed firms as well as sometimes newer companies that are growing quickly. This year that meant it missed some major gains not only in Tesla, but also in many other impactful firms such as Zoom, Moderna, Docusign, and Square.

If we look at a more comprehensive, broad-based U.S. stock exposure such as the Vanguard Total Stock Market ETF (VTI), which holds about 3,500 stocks including all the ones mentioned above, 2020 performance through December 12 was 17.7% compared to an S&P 500 index tracker like the SPDR S&P 500 ETF Trust (SPY) of 15.6%. That difference will ebb and flow, but over longer periods such as the last 15 years, the greater universe of the Vanguard Total Stock Market ETF has helped performance, returning 9.8% annualized compared to 9.5% for SPDR S&P 500 ETF Trust. A measure of tax efficiency, as measured by Morningstar’s Tax Cost Ratio, also shows that the Vanguard Total Stock Market ETF was more tax efficient, with a tax cost of just 0.47% over that 15 years compared to 0.60% on SPDR S&P 500 ETF Trust.

We see the potential for similar situations around the world, specifically in Canada where the more common S&P/TSX 60 index holds, as the name implies, 60 of the larger Canadian-based public companies. That is well short of what we see in something like the Vanguard FTSE Canada All Cap ETF (VCN.TO), which holds over 180 Canadian companies. That meant any fund tracking the S&P/TSX 60 index missed out on some exposure to fast growing technology firms like Kinaxis or Lightspeed.

Certainly not every company yet to be included in the S&P 500 or the S&P/TSX will be good for performance, but our approach for every market—be it the U.S., Canadian, or International—is why not own all the companies as the building block for a well-diversified global portfolio?

Utilizing our core and satellite approach, we view broad, entire market exposure as the starting core positions for any client. We can then look to other areas of the market, such as academically proven factors, or small thematic tilts, to slightly overweight a particular area. In our view, this is the only way to ensure we will always have some exposure to the better performing stocks. Whatever the Tesla or Zoom is of 2021, we want to ensure we have some exposure to it.

1 S&P Down Jones Indices, S&P Global

All Performance data from Morningstar Direct, December 12th, 2020

Indexes are unmanaged baskets of securities that are not available for direct investment by investors. Index performance does not reflect the expenses associated with the management of an actual portfolio. Past performance is not a guarantee of future results. Foreign securities involve additional risks, including foreign currency changes, political risks, foreign taxes, and different methods of accounting and financial reporting. Emerging markets involve additional risks, including, but not limited to, currency fluctuation, political instability, foreign taxes, and different methods of accounting and financial reporting. All investments involve risk, including the loss of principal and cannot be guaranteed against loss by a bank, custodian, or any other financial institution.

Stock prices rise and fall based on changes in an individual company’s financial condition and overall market conditions. Stock prices can decline significantly in response to adverse market conditions, company-specific events, and other domestic and international political and economic developments.

Filed Under: Articles, Investment Management Articles

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"Cardinal Point" is the brand under which the dedicated professionals within the independent Cardinal Point Group of Companies collaborate to provide financial and investment advisory, risk management, financial planning and tax services to selected clients. Cardinal Point comprises two legally separate companies: Cardinal Point Wealth Management, LLC, a U.S. registered investment advisor and Cardinal Point Capital Management Inc.is a U.S. registered investment advisor and a registered portfolio manager in Canada (ON, QC, MB, SK, NS, NB, AB, BC). Advisory services are only offered to clients or prospective clients where the independent Cardinal Point firms and its representatives are properly registered or exempt from registration. Each firm enters into client engagements independently. This website is solely for informational purposes. Past performance is no guarantee of future returns. Investing involves risk and possible loss of principal capital.