15 October 2020Asset management analysis

Stocks are not all created equal

Much has been said about what a gigantic proportion of the S&P 500 the top 10 stocks comprise. What is less often discussed is what happens to the returns of the S&P 500 when you remove the top performers, one at a time.

I have never seen analysis quite like this, and it is fascinating (and a bit scary) to note what happens if you remove Apple and Amazon from the S&P 500. (Reminder: the S&P 500 is an index of 505 companies and is weighted by ‘market capitalisation’. If you want to know why it isn’t 500, feel free to email me.)

Figure 1, S&P declining returns, highlights how sensitive—and reliant—the S&P 500’s winning track record is to the performance of just two mega-cap companies. It was compiled by ACR.

Figure 1:

Source: Alpine Capital Research

What exactly is market capitalisation, also called market cap, and what does it mean to be a “market cap weighted fund” or index?

Market cap weighting means the most valuable companies have more shares, more value, and more influence on the performance of an index (or index fund) than the less valuable companies in the same index. For example if a company is worth $200 billion it will comprise twice the weighting (representation) in the index of one worth $100 billion.

How big is big?

The market cap of the entire S&P 500 was roughly $26.7 trillion as of mid-February 2020. The market cap was $27.1 trillion on September 30, 2020. That means if we divide by 505, the mean market cap is $53 billion.

This number undoubtedly overstates the average: if we take out the market cap of the top five stocks the mean drops by 20 percent to $43 billion. If we take out the top 10 largest companies, which are 28 percent of the entire index, the mean of our remaining 495 stocks is down another 10 percent to $38 billion.

In fact, according to S&P, the median market cap in the index is only $22.7 billion. The smallest company in the S&P 500 has a market cap of only $2 billion. That means the largest company in the index has a 1,000 times higher weighting in the index than the smallest company.

Also interesting to note is that the largest 40 companies in the S&P 500 index are worth more than the other 465 companies put together. Investors in the index—or captives benchmarking their equity portfolios against it—should understand that their portfolio is being benchmarked against about 10 companies that comprise almost a third of the S&P 500 index.

What is the effect of the “overweighting?”

If you were invested in the S&P 500 this year through the end of September 2020, your investment was up about +5.6 percent. Not too bad if you can forget the stomach-churning 33 percent decline you suffered in the first 82 days of the year.

But how much of that 5.6 percent came from just a few names? In the first nine months of 2020, if you removed the performance of Apple and Amazon, the S&P 500 would be up less than 1 percent. If you took out the next biggest company—Microsoft—you have now lost money year to date, with the balance of the index down about 1 percent this year, instead of up 5.6 percent.

If you take out the top 10 companies one by one, the S&P 500 returns quickly go from +5.6 percent to -4.2 percent in the first nine months of this year.

It is a little reminiscent of the “eggs in a basket” metaphor.

Don’t forget volatility

As a captive insurance company owner or manager, your primary concerns are quality, liquidity, volatility, suitability, and performance. Asset managers and advisors such as me aim never to have a captive owner look at their portfolio and see that in any three-week period they can lose over a third of their equity portfolio, as investors in the S&P 500 experienced in March of this year. That is why you will almost never see the index as an investment in a captive portfolio.

Reducing volatility is a goal of a few (but not all) asset managers. There are lots of ways to reduce volatility in equity portfolios. Some are as simple as allocations to cash, balancing between “growth” and “value” equities or allocating some of the portfolio to international equities. Others are more sophisticated, such as having “long/short” portfolios, options-writing strategies, and other forms of hedging.

Not every strategy is suitable for every captive, and captive owners should heed the mantra of our chief market strategist, John Stoltzfus, who says the utmost importance is to “know what you own, and why you own it.”

Jack Meskunas is an executive director of investments at Oppenheimer & Co. He can be contacted at: