Lok Provides Key Differences in DJIA, S&P 500; Are Investments in Latter Diversified?
The Dow Jones Industrial Average (DJIA) is one of the oldest, best known, and most commonly used barometers to measure the performance of the US stock equity market. Yet, critics lament that a percentage change in the DJIA cannot be interpreted as a definite signal that the entire equity market has dropped by the same percentage. The reason is because the DJIA is price weighted.
For example, a $2 increment in the price of a stock that is currently at $100 will have the same effect on the index as a similar price change in a stock whose current share price is just $10. For the $100 stock, a $2 increment is just 2% on the upside, but for the $30 stock, it’s a 20% change. For this reason, critics of the DJIA prefer the S&P 500 Index when it comes to representing broad stock market sentiments.
Relative to the DJIA, the S&P 500 is larger in terms of market capitalization as well as being more diverse. The DJIA includes only 30 companies and represents in market value roughly a quarter of the entire US stock market. But the S&P 500 includes 500 companies and represents about 70% of the entire US equity market. Most importantly, the S&P 500 is capitalization weighted, meaning a 5% price movement in all stocks will move the entire index by 5% as well.
Investments Based on S&P 500 Are Diversified, Right?
Some may ask whether investing in an exchange-traded fund (ETF) or passive fund based on the S&P 500 means an investor is well diversified across a wide spectrum of companies from different industries? The answer is, not quite.
Considering the 500 component stocks of the S&P 500 and their respective weights in the index, we can discover some interesting facts. (Note that the following statistics are derived from 462 companies on the S&P 500 that have released their 2015 year-end results.) They include the following:
- The top 19 companies accounted for 30% of the market capitalization. This group includes such familiar companies as Exxon Mobil, Apple, JP Morgan Chase, Coca-Cola, Google, and Pfizer.
- The top 31 companies accounted for 40% of the market capitalization. In addition to the top 19, those in the top 20-31 spots include Wal-Mart, PepsiCo, Oracle, Philip Morris, Citigroup, Verizon, Abbott Lab, McDonald’s, and Goldman Sachs.
- The top 50 companies account for 50% of the entire S&P 500 market capitalization.
So, despite being market-capitalization weighted and seemingly diversified across 500 companies, the S&P 500 behaves more like an aggregated proxy for the top 50 companies. In other words, investors who invest in ETFs and passive funds based on the S&P 500 are essentially putting 50% of their money into the top 50 companies and are not quite as diversified as the title of the index suggests.
Short List of Companies Earn Most of the Profits
We examined the component weights of the S&P 500 companies, but what about the distribution of corporate profits? On 2 March 2016, USA Today published an article revealing that in 2015, “6% of Companies Make 50% of U.S. Profit.” The article notes that even though US corporate earnings in 2015 shrunk, profits were concentrated in 28 companies in the S&P 500. The following table lists the top 10 companies by profits and their respective percentage earnings relative to total net income generated by the 500 companies in 2015:
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The implications are simple: Investing in index funds based on the S&P 500 may not be as well diversified as before and carries a different risk profile.Compared with 2014, when it took 52 of the 500 companies to generate 50% of the total profit, the trend toward a concentration of profits in a small number of companies seems to be moving quickly. Of the 28 companies noted in the USA Today article, five are finance related and 10 are IT related, which also reveals the domination of these two industries.
It would be interesting to know if the same situation is occurring in developed economies in Asia, such as Hong Kong and Singapore. Look for a similar article about these locales if the required data become available.
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