Doug Flynn, CFP, of Flynn Zito Capital Management, LLC discussing major Stock Market Indices.
Doug: ...you have different ways that you can make up an index. The S&P, as most people are familiar with, are the 500 largest companies in the United States, but it's weighted towards the size of the companies.
Ali: A bigger company has a greater influence...Apple.
Doug: Correct. Apple is the biggest one. You have Exxon, and those. And so the top ten holdings in the S&P 500, is about 18% of every dollar you invest are in the top ten holdings. So that's that type of index. It's made up of market capitalization is what they call it.
Ali: So that's why Apple if Apple has a bad day, it could affect your investments if you're well-diversified, even if you're not directly invested in Apple.
Doug: That's correct. And convesely the Dow, which is interesting because it's an older index - it goes back to the 1800s -it's just a price weighted index, and all that means is that a stock that has a higher price weights more heavily in there. All these really are, no matter how you slice them, are just a proxy for what people think the market is doing overall. Unless you're in those 500 stocks, or those 30 stocks that are in the Dow, that doesn't necessarily mean that that's what you're going to earn, but it approx-able for is the market doing well; these are the things that we look at.
Ali: Is it a good proxy in your opinion?
Doug: I think over time it is a good proxy, it's what everyone seems to measure themselves against. Interestingly enough, the Nasdaq, the other one, there's 3000 stocks. So they're all different numbers, but I think overall, they give you an idea of what's in there, what the market is doing on average. It's something to look at as a beginning point.
Ali: You talk about the S&P being capitalization-weighted, the Dow being price-weighted, is there anything that's equal with it?
Doug: Yeah, you can actually, it's interesting, if you take the S&P 500, and there are equal weight S&P 500 Index Funds.
Ali: So it's all of those stocks, but they're all given equal weight?
Doug: So instead of having the top ten of the S&P 500 in a typical index be 18% of the portfolio, it would be 2% of the portfolio, because 0.2% of all 500 stocks are going to be in there. And, if you look at it historically, it has outperformance relative to the average S&P 500, because the smaller of the 500 stocks have more in there, and so typically those companies are going to grow bigger...
Ali: So if I like the assortment of stocks, and I want to be exposed to a lot of it, but I'm tired of Apple influencing my portfolio; I don't want to get out of it, I just want it to have equal weight as everything else.
Doug: Or maybe you already have a bunch of Apple stock, and the last thing you want is to have even more Apple stock unknowingly. These are ways to be in the index, but do it in a different way. And there are other ways to index, but equal weight is the first one to look at.
Ali: Now we got something on this chart I want to bring up so we can look at on the different kinds of capitalization, I mean the different kinds of weighting. And you've got one called rules based, now what is that?
Doug: Rules-based is interesting, because what that means is that you can apply anything to the index. Indexing doesn't just mean capitalization. You can say, "I want to sort by value. I want to sort by the PE ration. I want to sort by the price to book. I want to sort by sales." And so you can weight and re-index, and there are ETFs that specialize in this type of thing, and if you look at them, nearly all of them over time have outperformance relative to the market capitalization weighting type of indexing. So they're things to look at because you might find that there are companies that have lower price to book is a better measure than just, "I'm buying the largest companies in the United States, because they're the largest."
Ali: A lower price to book is a company whose book value is trading lower than what that company's actually worth, from an accountant's perspective.
Doug: Exactly, if you broke it up or sold it based on its parts. There are many different measures, and this is a good way to get online and look at different types of indexing, and different types of weighting that you can do, and there are funds that do that for you, or you can just look at it yourself, and dig deep in there and find what are the holdings that are in there that might not be as big a weighting in the typical index fund that's already in your 401k and you probably own outright.
Ali: And that's a good trick. Using these different things to make sure you're not duplicating your investments in different indices.
Doug: Yes, we call that overlap. You might not realize, with Apple as that example you have it in three different places being such a big percentage. That's fine if it does well, but not so fine if it doesn't.