As an active trader/investor, I spend many hours each day conducting my due diligence on the markets. This involves reading many articles/opinion pieces about the factors influencing the direction of the broader markets as well as my individual equities. I love when I come across information that furthers my understanding of why markets move the way they do. This past week, I discovered something quite interesting regarding the composition of the S&P 500 that I felt would be great to pass along.
The S&P 500 comprises 500 different companies across many different business sectors. As you might imagine, since this is a capitalization-weighted index, not all stocks influence the index’s price action equally. What is most surprising to me, however, is the degree to which just a few companies exert outsized influence due to their market cap size.
10% of this index is comprised of only three individual companies – Microsoft (MSFT), Apple (AAPL) and Google parent Alphabet (GOOGL). What’s even more astounding is that the next 10% of the index adds only seven more equities to the mix – these include familiar names such as Exxon Mobil Corp. (XOM), Amazon (AMZN) and Wells Fargo (WFC) among others. Doing the math, we realize that only 10 companies make up one-fifth of the S&P 500’s value – not quite as diversified as you might think!
Continuing further “down the rabbit hole”, you find that adding just nine more companies takes you to 30% of the index, another 13 gets you to 40% and 18 more takes you to the halfway mark. This means that 50% of this index is made up of only 50 companies. Furthermore, the bottom 30% of the index’s weight is spread across 379 companies.
Why does this matter? As the broader markets have been in a bullish trend since April 2009, many individual investors have turned to investment products that mirror the performance of the broader indices as a way to be a less active investor yet benefit from markets continuing to rise all the while feeling some “safety” in the fact that they are well diversified in their portfolios. These statistics show that isn’t the case – at least to the degree many investors would expect. Five of the eight largest companies by market cap are in just two sectors – technology and the internet. If investors are seeking some safety in diversification, this concentration in two areas doesn’t meet the “smell test”. The SPY, an exchange-traded fund many investors use as a proxy for the S&P 500, has an enormous market cap of $179,603.8M – a great deal of money chasing a rather small group of stocks. This is what creates “crowded trades” and when money wants to move to the door, watch out below!
Does this mean we should avoid using these products in our trading? Certainly not if we know how to hedge the risk we have through utilizing options. I trade the SPY quite actively in my portfolio in hedged options trades to take advantage of both bullish and bearish price action in the SPY. By understanding the composition of this ETF, I can take a look at the trends of those companies that significantly move this investment as a helpful guide to placing successful trades. With almost one-third of the holdings deriving from information technology and financials, it’s important that I understand the factors impacting those sectors both currently and forward-looking. Knowing what you own in detail helps you to effectively plan your trades and trade your plans leading to enviable success in the markets. This is how we learn to trade as members of the OptionsAnimal community – and you should too!