Are All Stock Market Indexes the Same?

The S&P 500 tracks the performance of 500 of the largest companies in the U.S. by size, as measured by their market capitalization (or market cap). Market cap is the company's total stock market value, calculated by multiplying its stock price by the number of shares issued by the company. The bigger a company's market cap or valuation is, the larger its footprint or representation in the index.

In addition to market cap size, companies admitted into the S&P 500 must meet other membership criteria, including being profitable for a year and the most recent quarter.

The S&P 500 has a selection committee that often meets four times a year, but there is no set cadence to their meetings or index rebalancing. Because the timing of index rebalancing can vary and the index has additional considerations for inclusion beyond market cap, the selection of companies that make up the index can sometimes lag behind changes in the broader investing landscape. Tesla, for example, took a long time to get added to the S&P 500, despite its outsized stock market valuation, for a host of reasons, including the index's profitability requirements.

While the S&P 500 and other market cap-weighted indexes are popular, investors have other practical approaches for indexing at their disposal, including fundamentally weighted equity indexes.

Fundamentally weighted indexes (also called fundamental indexes) measure stocks for inclusion in the index based on a company's economic size. Key inputs include:

• Operating cash flow: The amount of cash a company keeps after covering all its expenses reflects the actual cash available to reinvest in its business.
• Dividends and buybacks: Dividends are earnings distributed to shareholders, and buybacks are shares a company repurchases to help return capital to shareholders, without triggering taxes.
• Sales: A broad measure of the money a company receives for goods and services sold.

A company's stock price can reflect the health of the company as measured by recent growth and profits, as well as more subjective inputs (such as investor excitement about potential future growth, short-term news headlines, and group-think mentality). So, creating indexes based on stock price valuation alone can help capture broad market returns, but it also has limitations including valuation and concentration risks.

Market cap-weighted indexes are driven to buy more of a stock as its price rises and may sell or buy less after the stock price goes down. It thus buys more shares at higher prices, rather than lower prices. This creates a bit of a popularity contest in which prices can be based on market sentiment rather than the health of the underlying company.

Over time, concentration risk (the risk of owning too much of a single stock or group of stocks) in market cap-weighted indexes tends to fluctuate. Over the past 30 years, concentration risk in the S&P 500 index, as measured by the weight of the top five companies, has ranged from a low of 10% to a high recently of over 30%.

Fundamentally weighted indexing offers a different lens on the stock market. Instead of looking at stock prices, fundamentally weighted indexes measure companies based on their actual economic footprint—things like company sales, cash flow, and dividends. This approach breaks the link between a stock's price and its weight in your portfolio, helping you avoid overpaying for “popular” stocks.

Over longer time periods, fundamentally weighted indexing has historically shown better performance (relative to risk) than market cap-weighted strategies in less efficient markets, such as U.S. small cap stocks, international stocks, and emerging market stocks. But there can also be benefits to pairing fundamentally weighted indexing strategies with market cap-weighted strategies in more efficient markets, such as U.S. large cap stocks.

Fundamentally weighted indexes have historically reflected a value tilt, while market cap-weighted indexes have reflected a growth tilt. These tilts can lead to different stock price performance among different times of market cycles. In a fast-moving market rally, for example, fundamentally weighted indexes may lag behind market cap-weighted indexes. Over longer time periods, fundamentally weighted indexes have historically been competitive with market cap-weighted indexes.

Fundamentally weighted index strategies have higher expense ratios than market cap-weighted index strategies, so they are not the lowest cost option available to investors. In addition, if you're considering fundamentally weighted index strategies, remember that patience is key. As with any stock market investment, a time horizon of five years or longer is a good idea for holding your fundamentally weighted index investment.

You don't have to choose just one indexing style. Combining different indexing styles, such as traditional market cap-weighted indexes with fundamentally weighted indexes, can create a more balanced portfolio.

Market cap strategies provide cost-effective exposure to the various asset classes. Since these strategies are essentially the most recognized benchmarks, they have historically produced benchmark-like performance and typically provided the lowest cost solution to capturing broad market returns.

Fundamentally weighted indexing has often differed from the traditional market cap benchmark over the short term, but it offers attractive reward potential over the long run in the form of excess return (or alpha). While fundamental strategies are often less expensive than active mutual fund managers, they typically have a higher cost than market cap-weighted strategies.

In recent years, US market cap-weighted indexes for large company stocks have become highly concentrated in growth stocks that look very overvalued by traditional valuation metrics. On a long-term view, having exposure to more value-oriented stocks via fundamentally weighted indexing strategies can make sense. We believe combining fundamental and market cap indexing together provides an additional layer of diversification and the potential for alpha in a cost-effective manner.