Knowing What Your Index Fund Invests in

Investors need to be aware of changes in the major stock indexes.

Index fund investors, of course, need to know how the indexes are composed so they’ll know what’s in their portfolios and the risks they are taking. Investors in non-index, or active, funds should know what’s in the indexes, because mutual funds usually are measured against the indexes. Many mutual fund managers try not to stray too far from the indexes, because they don’t want to risk dramatically underperforming those benchmarks.

Investing in index funds isn’t investing in “the market.” The indexes are created by people, and decisions are made when indexes are compiled. In addition, market action changes the composition of the indexes when prices of some stocks rise more than others. That’s what I want to look at today.

The most dramatic changes in recent years have been in the composition of the large company stock indexes, especially the S&P 500. In the last few years, a few large companies, mostly technology companies, have outperformed the rest of the market.

Because of the disparity in returns by firms such as Facebook, Alphabet/Google, and Apple, the technology sector now is 25.7% of the S&P 500. Its weighting has increased by 1.93 percentage points so far in 2018. Technology was 20.8% of the index at the start of 2017, which was a big increase from a few years earlier. The next-largest sectors are financials (14.7%) and health care (13.7%). Much of technology’s share increase has been at the expense of consumer staples, which has lost 1.42% of its index share in 2018.

The once-mighty industrials now are only 9.9% of the index, and consumer staples are only 6.7%. Energy, once the largest weighting, is down to 6.2%. In fact, the seven smallest sectors in the index together are only about a third of the index. There are 11 sectors overall. The only time technology’s weighting was higher than today’s level was during the peak of the tech stock boom from December 1999 to September 2000.

Consumer discretionary, which includes Amazon and Netflix, is up to 12.9% of the index, increasing by 0.65% in 2018.

But technology is not as dominant when we venture outside the large company indexes.

In the S&P 400, which is a mid-size-company index, and the S&P 600, which is a small-company index, technology is around 15% of each. Consumer staples also has an outsized weighting in the S&P 500 compared to the other indexes. It is 7.4% in the S&P 500 but around 3.2% in the other two indexes. Industrials, on the other hand, is 18.7% of the small company index and 15.3% of the mid-size company index, but it is only 9.9% of the S&P 500. Materials and real estate also have much lower weightings in the S&P 500 than in the other two indexes.

There are lessons investors can draw from examining the details of the indexes and the changes in them.

An investor who believes the market and economy will continue to be dominated by the big tech companies would want to stick with the S&P 500 or another large-company index. But an investor who believes that sector might be overvalued or due for a correction might prefer a different index.

If you want a more balanced stock allocation, you probably want more than S&P 500 index funds in your portfolio. You could add either or both of the other two indexes, or you might look at a total market index fund. If you favor industrials, materials and real estate, you definitely want to invest outside of the S&P 500.

The Data

Retail sales seem to be making a comeback after going into hibernation the first few months of the year. Sales for April increased 0.3%, and March’s sales increase was revised higher to 0.8% from 0.6%. After excluding gas and autos, sales still rose 0.3%. The sales data were strong enough to trigger a sharp rise in interest rates and a decline in stocks on Tuesday.

Another strong report was the Empire State Manufacturing Survey, which rose to 20.1 from 15.8. The regional manufacturing surveys had declined significantly last month, so the increase surprised analysts. In general, businesses are less worried about a trade war, and that improved their assessments of the next six months.

The Philadelphia Fed Business Outlook Survey also had a big surge, to 34.4 from 23.2. Firms were very positive about current conditions and reported a 45-year high in new orders. They also were optimistic about the next six months, though that measure declined a little from last month. The manufacturers report price increases of both their inputs and goods produced.

Industrial Production again is reflecting the strength that’s been in the surveys and anecdotal reports about manufacturing. Production was up 0.7% for the month, and last month’s number was revised higher to 0.7% from 0.5%. The manufacturing component rose 0.5% for the month, though last month’s number was revised down to unchanged from a 0.1% increase. Even better, business equipment rose 1.2% in the latest month.

The Housing Market Index from NAHB also was positive, rising to 70 from 68. There continue to be fewer first-time buyers than in normal times, yet builders are optimistic and report strong sales.

Housing starts generally were positive. In the headline numbers, both starts and new permits declined. But the declines were concentrated in apartments, which had an unusually high increase last month. In single-family homes, starts increased 0.1% and permits increased 0.9%. Over 12 months, starts are up 10.5% and permits are up 7.7%.

The Leading Economic Indicators as reported by The Conference Board increased 0.4%, compared to 0.3% last month. This is the sixth consecutive month of increases. This indicates a recession is unlikely in the next six months.

Consumer Sentiment, as measured by the University of Michigan, was unchanged at 98.8. That’s a little below the highs of earlier this year but still very near the highs since the financial crisis.  

New unemployment claims increased by 11,000 to 222,000. The four-week average declined because of sharp decreases in the last few weeks, giving the four-week average its lowest level since 1969.

The Markets

The S&P 500 returned 1.02% for the week ended with Wednesday’s close. The Dow Jones Industrial Average rose 1.05%. The Russell 2000 added 1.41%. The All-Country World Index increased 0.96%. Emerging market equities did the best of the week, returning 1.44%.

Long-term treasuries fell 1.00% for the week. Investment-grade bonds lost 0.39%. Treasury Inflation-Protected Securities (TIPS) dropped 0.52%. High-yield bonds declined 0.08%.

The dollar rose 0.37%.

Energy-based commodities returned 0.73% for the week. Broader-based commodities were unchanged. Gold declined 1.67%.

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