Education and financial literacy are core elements to our culture at Covenant Wealth Strategies. In the complex world of financial markets, there exists a constant need for clarity, understanding and education.
For example, there are a variety of benchmarks and indexes that represent the market. Each index has its own nuance - some are cap-weighted, price-weighted or equal-weighted. What does this means and why does it matter? We’ve outlined our answers to seemingly simple questions we are frequently asked to shed light on important market questions.
What is an index?
A market index is a hypothetical portfolio of investment holdings that represents a segment of the financial market. The calculation of the index value comes from the prices of the underlying holdings.
How is the market doing?
You might get a response that varies from person to person. One respondent might quote the return of the oldest U.S. stock index - the DOW Jones Industrial Index (a measure of 30 stocks on a price-weighted basis). Others might cite the S&P 500 (comprised of approximately 500 of the largest publicly traded U.S. companies weighted by market capitalization a.k.a. "cap weighted") as a more broad look at U.S. markets. Alternatively, others may quote the Nasdaq (also market-weighted and mostly growth and technology companies) or you might get an entirely different answer if you ask the question to someone who is globally focused. The ACWI (All Country World Index) is an index that measures the average return of 3,000 companies from 23 developed countries and 25 emerging markets. The ACWI is also cap-weighted. There is also the Russell 2000 Index, which is comprised of approximately 2,000 small-cap companies and the Aggregate Bond Index, which measures the investment grade, U.S. dollar and fixed-rate taxable bond market.
You might assume that two indexes which cover the same market will have the same results, however that may not be the case. In fact, their actual returns will differ significantly in some cases. A key part of an index methodology is the set of rules that govern the index’s construction.
How is the weight of each position within the index determined?
Not all companies are equal in an index. The term cap-weighted refers to the relative value of an organization in comparison to the rest of the index. More specifically, the "value" or "capitalization" of a company equals the number of shares outstanding x the price per share. Capitalization - or "cap" - weighted indexes give greater weight to stocks that are the largest in terms of their contribution to the index value and the upward and downward performance of the index. The S&P 500 is an example of a cap-weighted index.
In a price-weighted index, each company's stock is weighted by its price per share, and the index is an average of the share prices of all the companies. Price-weighted indexes give greater weight to stocks with higher prices (not the same as value or worth) in terms of their contribution to the index value and the upward and downward performance of the index. The Dow Jones Industrial Average (DIJA) is an example of a price-weighted index.
Equal-weighed indexes give equal weight to each of the companies/stocks that make up the index in terms of index value and the upward and downward performance of the index. The RSP is an example of an equal-weighted exchange traded fund (ETF) that tracks the S&P 500 equal-weighted index. Interestingly, the RSP (equal-weighted ETF) measures the same stocks as the S&P 500, but the performance of the two are often vastly different because of the difference in weighting methodology (RSP return in 2022 was -11.6 vs. S&P 500 -19.4; the 2023 returns RSP +11.81 vs. S&P 500 +24%).
What is the purpose of an index?
An index is used to help investors compare current stock price levels with past prices and/or to calculate the performance of a specific group of stocks in a sector, industry or the broad financial market. It may also may be used as a component of a benchmark to measure/compare an active investors performance based on their investment choices.
Why did it matter in 2023?
There was a lot of talk about gains in the S&P 500. Those gains in 2023 were powered by the “Magnificent 7” for much of the year. Those stocks were given approximately 30% weight of the S&P 500 cap-weighted index and had a huge impact on the index’s returns (over 24% for 2023). Meanwhile, the average stock in the same index, measured by the equal-weighted index had a return of just below 12%. In fact, 71% of stocks within the S&P 500 had a negative return for the year.
To simply compare the performance of a portfolio to the S&P 500 can be misleading as the components of a well-diversified portfolio typically include mid-cap stocks, small-cap stocks, fixed income holdings and international investments. Diversification is important to manage the volatility in a portfolio.
What does this mean?
In our work together, it is important to keep a long-term perspective and stick to your individualized financial plan. “We seek to align a variety of factors, including risk tolerance and time horizon within different portions of a client's portfolio with the objective of assisting our clients to achieve their goals," said Randy Eveland, CFP, RICP, CDFA®, Wealth Advisor. For example, we diversify to manage risk-avoiding overexposure to stock styles, sectors, themes, and industries to mitigate potential downturns in those stock styles, sectors, themes, and industries and provide a smoother return profile. Within our tactical Protect and Advance strategy, we also use technical analysis to determine if we want to posture defensively in times of heightened market volatility.
We carefully and actively monitor and make investment selections as a team to protect and advance our client's best interests.
If you have specific questions or would like to discuss your own investment strategy or financial planning needs, we welcome you to call us at 302.234.5655 or email us at firstname.lastname@example.org to set up time to discuss further.
All investing involves risk, including loss of principal. Indexes are not investments, do not incur fee and expenses and are not professionally managed. It is not possible to invest directly in an index.
There is no guarantee that a diversified portfolio will enhance overall returns or outperform a non-diversified portfolio. Diversification does not protect against market risk.
This material is for general information only and is not intended to provide specific advice or recommendations for any individual. This information is not intended to be a substitute for specific individualized tax advice. We suggest that you discuss your specific tax situation with a qualified tax advisor. The charts above are for illustrative purposes only.