Standard & Poor’s is a financial services company owned by McGraw Hill that rates stocks and bonds according to their risk profiles. Standard & Poor’s began in 1923 with an index of 233 companies. The present form of the Standard & Poor’s 500 Index (S&P 500) came into being in 1957 when the number of companies grew to 500. Since then, the S&P 500 has become a leading indicator for the overall U.S. stock market. Mutual fund managers use it as a guide to determine how well they are doing. In addition, index funds, such as the Vanguard 500 Index Fund and Exchange Traded Funds (ETFs), are based on the S&P 500. Understanding what the S&P 500 is can help you make a better return on your investments in the stock market.
The designers of the S&P 500 wanted to create an index of large-cap companies that better reflected U.S. stock markets. Up to that time, the Dow Jones Industrial Average had been the leading indicator, but had problems in that it only contained 30 companies and measured change in terms of dollar amounts rather than percentages.
By including 500 widely traded stocks in the index and calculating change in terms of a market value-weighted index, the S&P 500 has come to represent about 70 percent of the total value of U.S. stock markets. Because of this enormous volume, it has become a major indicator of movement in the marketplace as a whole.
A common misconception is that the S&P 500 automatically selects the 500 largest companies by market capitalization and revenues. A team of analysts and economists at Standard & Poor’s select companies and their stocks in terms of:
- market size
- industry grouping
The industries contained in the S&P 500 include energy, industrials, information technology, health care, financials, and consumer staples.
The S&P 500 uses a weighted average market capitalization when computing the effect each company has on the index. First, you compute the “market capitalization” using the following equation:
[number of shares] x [price per share] = market cap
If a company has 800 million shares of stock that are selling at $50 a share, this equals a market capitalization of $40 billion. Once the market capitalization has been computed for all 500 companies, they are then added together to get a total for the S&P 500. From there, each company is assigned a percentage of the total, which represents their influence on the index. The larger the percentage of market weight, the more impact the company has on the overall S&P 500.
The main advantage of the S&P 500 is that it includes leading companies in leading industries that represent around 70 percent of the value of the U.S. equity market. It includes a highly diverse assortment of larger companies that reflect every relevant area of the U.S. economy, making it one of the best benchmarks in the world for large-cap stocks.
Even though Standard & Poor’s tries to cover all areas of the market by having a base of 500 companies, in practice 45 companies comprise more than 50 percent of the index’s value. And because it gives more weight to larger companies, the S&P 500 has a tendency to reflect the price fluctuations of a fairly small group of companies. According to investment advisors, another disadvantage of the index is the relative absence of any foreign companies. (This will only become more of an issue, as the index committee has stated that only U.S.-based companies will be added in the future.)
Most investment firms offer an S&P 500 index fund. The key difference between many of these seemingly similar funds is that each firm charges a different amount to manage the fund. This management expense ratio varies considerably depending on the investment firm. The reason the Vanguard 500 Index Fund is popular is because of its low expense ratios.
Exchange Traded Funds (ETFs) are securities that track the S&P 500 Index. Traded like stocks, they represent different exchange-traded fund families that track the various sectors of the index. Some of the more common ETFs include Vanguard Index Participation Receipts (VIPERs), Barclays Global Investors iShares, and Standard & Poor’s Depository Receipts (SPDRs), also known as “spiders.” For more information on spiders, see the article What Are S&P Depository Receipts (SPDRs)?