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Throughout the year we’ve had the opportunity to have many conversations with players about investing, and the most common question we get is about investing in S&P500 ETF’s. So let’s dive in, but first cover the basics:
What are S&P500 ETF’s?
ETF’s (Exchange-Traded Funds) are investment vehicles that pool together a collection of stocks or bonds into a single fund. ETF’s can track various groups of stocks (businesses), for example the S&P500, which includes 500 of the largest publicly traded companies in the United States (largest = worth the most based on their Market Capitalization, see bottom for definition). So by buying “shares” in an ETF, you’re essentially buying “shares” in those 500 companies.
Are all S&P500 ETF’s the same?
While similar S&P500 ETF’s are marketed and sold by many different financial institutions, one of the biggest things to take note of is whether the ETF is Market Weight or Equal Weight.
The S&P500 is a market capitalization weighted index (see market cap def’n below*), which means the companies with the largest market caps will have the greatest weights in the index. In other words by owning a Market Weight S&P500 ETF, you own more of the biggest companies and less of the smaller companies. If you own an Equal Weight S&P500 ETF, you own the same amount of each company on the index.
What is the “Self-Fulfilling ETF Prophecy“?
Okay – so let’s take a step back & think about this logically… someone buys the S&P500 ETF (Market Weighted), which as of today $100 would buy you $6.50 worth of shares in Apple at their current share price, $5.80 shares in Microsoft. etc., the top 10 companies you own would represent approx. $37 of your $100. When people purchase these ETF’s, they are purchasing the stocks, and it justifies the share price in the market, and drives the price up (supply/demand). So the more that people buy these ETF’s, a higher portion goes to the top companies, making them grow faster than the smaller companies on the exchange.
Why Does this Matter?
Okay first off, let me say that investing in an S&P500 ETF (market or equal weight) is NOT a bad thing; ETF’s are a great way to diversify your investment money across many different companies (for $100 you could not afford to buy individual shares of 500 companies), and historically the companies on the S&P500 have grown at a rate faster than many other indices’ group of companies. If you are contributing modest amounts of money monthly, and aren’t sure which companies are good investments, then you’re not alone in choosing an S&P500 ETF and may have even done well over the term of your investment because the top 10 companies (Apple, Microsoft, Amazon, Google, Tesla, Nvidia, Berkshire Hathaway, Facebook, Johnson & Johnson) have had tremendous performance.
But Wait !
When you consider a business’ valuation, and understand it’s stock price is partially based on actual business profits and partially based on how often & and what price people are buying it for in the market – you may come to the conclusion that a very large portion of your investment portfolio returns have been created with the popularity of ETF investing – instead of the actual underlying business you are investing in.
Who Does this Concern?
If you are investing modest amounts monthly and aren’t exactly sure which businesses are good investments – S&P500 ETF’s remain worthy investments based on the fact that the United States is the most capitalistic country in the world, and has some outstanding businesses leading innovation in many different aspects.
On the other hand, if you had a larger sum to invest – would you blindly spread it across 500 companies (450 of which you know nothing about), or would you use a proven investment strategy to select a portfolio of businesses you believe in?
Definition: Market Capitalization
The market capitalization of each publicly traded company listed on the market is determined by taking the share price and multiplying it by the number of shares outstanding. For example: If a company’s shares are trading at $10 per share, and there are 500,000 shares in total for that company, the market cap of that company is $5,000,000.
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