The hidden drag from the S&P 500 that can reduce outputs

Capital pressure charts are very popular. They will bring more pressure to larger companies. Perhaps the most obvious example is the S&P 500. However, researchers suggest that this type of index may complement other weight loss strategies. The question is why.

Hitting the index

Researchers at Intech and the London School of Economics believe their answer is in a 2019 paper published in the Journal of Investment Consulting. This builds on original research from Rob Arnott and others in a 2013 paper from the Journal of Finance. That second paper showed that if you weighed stocks equally, randomly or in a number of other ways called naive, you would generally outperform an index with a capital weight, such as the S&P 500, over the long term. In this case the longevity is measured in decades.

Multiplication

There are a number of ways to explain why some so-called naive records tend to dominate the S&P 500 in the long run, but perhaps the clearest explanation is better multiplication. The S&P 500 puts a pretty high weight on just a few stocks. Microsoft right now

MSFT
, Apple

AAPL
, Amazon, Facebook and Tesla

TSLA
makes up about a fifth of the value of the S&P 500 despite being only about 1% of the companies in the index. In a sense these companies weigh twenty times as much in the index as would give them equal weight. That excess weight can be considered a bad multiplier, and a long-term poor multiplier can be a drag on performance.

This is not to say that there is nothing wrong with importing large capitalist stocks, but there may be something wrong with owning too many of them in your portfolio.

The movement in the prices of these big names may not be offset by other stocks, given their large index weights, and they remain a drag on the portfolio. Other index building methods are better diversified.

Larger views

The research makes this clear by proposing a weighting formula that is even denser than the S&P 500. How does it perform? This is one of the few weight loss methods that is even worse than the S&P 500 itself. So other weighting methods may not do anything particularly subtle compared to the S&P 500, they just multiply better.

As another example, in the end, if you just held 100% weight in the largest single stock in the index, would you expect it to beat a group of 500 stocks over decades? Probably not, and in a sense, that’s the multiplication issue the S&P 500 suffers to a lesser extent. We know the value of multiplication for decades, but the S&P 500 does not use the lesson in addition to other index building methods.

The undoubted challenge is that big stocks are much easier to trade, you can move money in and out of big names like Apple and Microsoft. In contrast, it is harder for small companies to trade as easily when you are moving to bulk. That’s one reason the benchmark is against the S&P 500, and indices with a capital weight are usually biased. Other important methods might not scale as well if everyone followed them.

Nevertheless, the pressure of market capitalization may not be the best way to build a portfolio. You make up for some diversification by having some big companies take control of the portfolio. That could cost you about 1-2% on your annual returns over time if history is any guide.