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What's in your index?

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Last week we made a comment about which stock market index is suitable to use to run relative strength calculations, but we didn't give a good explanation as to why. Our preference is not to use the most commonly quoted index--the S&P 500 Index--but to use a less well-known index, the S&P 500 Equal Weight Index. We feel that using an equal-weight index provides a much better basis for investing and also provides a much easier to understand methodology for investing. So let's look at how each index is built.

The two most common indexes used are the S&P 500 Index and the Dow Jones Industrial Average. We are going to look at the S&P 500. This index is also the most commonly quoted benchmark in which most investors and investment companies base their success or failures of investing. The S&P 500 Index has been published since 1957 and contains 500 of the leading companies in leading industries and in the U.S. economy. Inclusion on the S&P 500 Index is determined by many factors, some of which are: location, market capitalization, public float and liquidity. (For a complete list go to www.standardandpoors.com.) A committee uses this list of factors to determine what companies are included and how much of the index that company "owns." This is called the index weight. The larger the company the more "votes" it has in the overall value of the index. This is called the float-adjusted market cap weighting, which we will refer to as market cap.

In taking apart the current makeup of the S&P 500, you begin to get the picture of how the index works. But you cannot invest directly into the S&P 500 Index that we discussed. You can do three things in an attempt to mirror the S&P 500 Index: Purchase individual stocks in the exact weighting of the index, buy a mutual fund that attempts to track the index, or buy an Exchange Traded Fund that tracks the index. The easiest and most transparent way to get exposure to the S&P 500 Index is to buy the SPDR S&P 500 ETF Trust (symbol SPY) ETF, which was created on Jan. 22, 1993. As we have commented before, we like to use ETFs due to their transparency and ease of being able to acquire real-time data versus mutual funds.

Now let's look into what exactly the SDY owns. Exxon Mobil Corp has the highest index weight at 3.23 percent. Next are Apple Inc. at 2.59 percent and Microsoft, garnering 1.84 percent of the total index weighting. It doesn't take too long to realize that the top 10 holdings in the index make up 18.90 percent of the holdings in the index. Of course it doesn't take a rocket scientist to realize that the remaining 490 companies get the remaining 81.10 percent but even that number is not equally distributed among the 490 companies. The next 10 holding of the SDY peel out an additional 11.85 percent. That is a total of 30.75 percent of the total weighting spread out over 20 companies, and 480 companies take up the other 69 percent.

The bottom line is that investing in the S&P 500 Index can make sense. If you are a passive investor who doesn't want to be involved in making decisions about what to invest in, you should easily achieve an almost identical return of the S&P 500 Index. However, you cannot invest in the true index, so you would have to hire someone to do that. Management fees, marketing fees and trading costs will all take from the profitability of your investment and its overall return.

Our take is that a true S&P 500 Index fund that attempts to mirror to the letter the S&P 500 fund should always underperform it, when you back out expenses. If the index fund outperformed the index then it most likely did not track the exact index. Maybe it took more risk than what you thought it was going to. On the vein of risk, when you start to break down how the index is built and you see that 30 percent of your investment is spread out over only 20 companies, it might be worth researching alternatives.

One alternative is to look at the logic of using the market cap weighting system, which places much more emphasis on large companies, or digging deeper to see whether using the same index with a different methodology might provide you more opportunities.

Next week we will look at the S&P 500 Equal Weight Index.

Editor's note: Agvisors provides commentary about agricultural markets, including grain, dairy, livestock, equities, financials, and energy, highlighted by a live weekly webinar discussing conditions and responding to questions. For more information, visit http://agvisors.com.



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