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S&P 500 Index Investing Overview: Definition, Calculation, and Examples
The S&P 500 is probably the most famous broad-market index in the world. And for good reason. Investors use it to judge the health of the US stock market and directly invest in it using index funds and ETFs.
But what is the S&P 500 exactly? How is it used and why should you, as an investor, care about it? In this article, we aim to answer all of these questions and more.
But what is the S&P 500 exactly? How is it used and why should you, as an investor, care about it? In this article, we aim to answer all of these questions and more.
Big ideas
- The S&P 500 is a stock market index that tracks the performance of 500 large-cap stocks considered the most representative of the US stock market.
- Replicating the performance of the S&P 500 can be done by investing in index funds and ETFs designed with the exact weighting of stocks.
- Index funds can be either mutual funds or ETFs, and there are a lot of them to choose from.
QUOTE
By periodically investing in an index fund, the know-nothing investors can actually outperform most investment professionals.
What is the S&P 500?
To understand what the S&P 500 is, you first need to understand stock market indices.
DEFINITION
A stock market index is a measure of a stock market’s performance that calculates the performance of a group of stocks based on some criteria as a proxy for that market’s performance.
You can think of an index like a hypothetical stock portfolio that best represents a market (i.e. the U.S. stock market). It calculates the price changes of that portfolio to provide you with an idea of the direction of all stocks in a given market.
The S&P 500 is an index that tracks the performance of the 500 largest companies in the United States. For this reason, we use it as a proxy of the performance of the U.S. stock market.
The S&P 500 is an index that tracks the performance of the 500 largest companies in the United States. For this reason, we use it as a proxy of the performance of the U.S. stock market.
S&P 500 visualisation of companies by market cap
Source: FinVizJust like all indices, the S&P 500 has certain criteria for a company to be included in it. Some of these include:
- A market cap of at least US$12.7 billion
- Being based in the U.S.
- Having a high trading volume
- Having a positive earnings performance in the last 12 months
As you can see, eligibility will filter out unprofitable, illiquid, and small companies. So, we should note that this is useful for investors who want to invest in a safe manner. Because it is only 500 of the many thousands of publicly traded US companies, it is not the most complete representation of the stock market.
If you wish to replicate the performance of the largest and most established companies, the S&P 500 is a great index to track. But there are other indices to use as a benchmark if you wish to include different kinds of stocks in your portfolio, such as smaller companies.
If you wish to replicate the performance of the largest and most established companies, the S&P 500 is a great index to track. But there are other indices to use as a benchmark if you wish to include different kinds of stocks in your portfolio, such as smaller companies.
A brief rundown of S&P 500 history
The S&P 500 is an “updated” version of an index that consisted of 233 companies in the United States, developed in 1923. The index as we know it today was developed in 1957, tracking the performance of 425 industrial stocks, as well as 60 utility and 15 rail companies.
In 1976, Vanguard, an investment management company, created the first mutual fund that tracked an index; Vanguard First Index Investment Trust. This allowed you to replicate the performance of the index by buying all of its constituents with a single investment. Today, known as the Vanguard 500 Index Fund VFINX, it has about $390 billion in assets under management (AUM).
In 1976, Vanguard, an investment management company, created the first mutual fund that tracked an index; Vanguard First Index Investment Trust. This allowed you to replicate the performance of the index by buying all of its constituents with a single investment. Today, known as the Vanguard 500 Index Fund VFINX, it has about $390 billion in assets under management (AUM).
Past performance doesn’t guarantee future results.
Another accomplishment that further helped the popularity of the S&P 500 was the commencement of futures trading based on the index by the Chicago Mercantile Exchange (CME) in 1982. The next year, options trading based on the S&P 500 was made available by the Chicago Board Options Exchange (CBOE).
More than a decade later in 1993, SPDR S&P 500 Trust, the first ETF that ever tracked the S&P 500, was created. It was listed on the American Stock Exchange under the ticker symbol “SPY” and was actually the first ETF that was traded in the U.S. as well. Today, it’s the largest ETF that tracks the S&P 500 index, with about $360 billion in assets under management.
A last but very important event you need to know is the change of the S&P 500 from a market-value-weighted index to a float-adjusted weighted one in 2005. Since then, the index wasn’t calculated based on the total market value of its constituents anymore but only the value of their publicly traded shares, excluding restricted ones. If that’s a bit confusing, don’t worry. In the next section, we will talk about it in more detail.
Another accomplishment that further helped the popularity of the S&P 500 was the commencement of futures trading based on the index by the Chicago Mercantile Exchange (CME) in 1982. The next year, options trading based on the S&P 500 was made available by the Chicago Board Options Exchange (CBOE).
More than a decade later in 1993, SPDR S&P 500 Trust, the first ETF that ever tracked the S&P 500, was created. It was listed on the American Stock Exchange under the ticker symbol “SPY” and was actually the first ETF that was traded in the U.S. as well. Today, it’s the largest ETF that tracks the S&P 500 index, with about $360 billion in assets under management.
A last but very important event you need to know is the change of the S&P 500 from a market-value-weighted index to a float-adjusted weighted one in 2005. Since then, the index wasn’t calculated based on the total market value of its constituents anymore but only the value of their publicly traded shares, excluding restricted ones. If that’s a bit confusing, don’t worry. In the next section, we will talk about it in more detail.
How is the S&P 500 calculated?
The S&P 500 is used as a proxy of the entire U.S. market because it consists of large and profitable companies with liquid stocks that have a large impact on the equity market.
The index is market-cap weighted, which means that larger stocks will have more weight in calculating the value of the index than smaller ones. The size is determined by the market capitalization of a company, which is the value of all of its shares.
The index is market-cap weighted, which means that larger stocks will have more weight in calculating the value of the index than smaller ones. The size is determined by the market capitalization of a company, which is the value of all of its shares.
DEFINITION
A mutual fund is an investment vehicle that professional money managers oversee.
A mutual fund is a type of open-ended fund that allows you to pool your money with other investors to be managed by professional investors according to the fund’s strategy.
An open-ended fund is simply a fund in which its managers will continually accept new capital by issuing and distributing new shares to new investors. All mutual funds are open-ended.
When you invest in a mutual fund, the managers will issue and give you shares according to the amount you want to invest. When you want to sell your shares, the managers will liquidate your positions, redeem your shares, and distribute your invested amount plus/minus any capital gains or losses.
Mutual funds can be actively or passively managed. Active strategies are based on the proprietary research and technology of the managers. Passive strategies are all about tracking an index like the S&P 500.
Due to the history of the index, S&P 500 mutual funds are ubiquitous. And for that reason, it’s easy to get overwhelmed by the question, “which fund should I choose?”. So, here are a few things to keep in mind when trying to select an S&P 500 mutual fund:
An open-ended fund is simply a fund in which its managers will continually accept new capital by issuing and distributing new shares to new investors. All mutual funds are open-ended.
When you invest in a mutual fund, the managers will issue and give you shares according to the amount you want to invest. When you want to sell your shares, the managers will liquidate your positions, redeem your shares, and distribute your invested amount plus/minus any capital gains or losses.
Mutual funds can be actively or passively managed. Active strategies are based on the proprietary research and technology of the managers. Passive strategies are all about tracking an index like the S&P 500.
Due to the history of the index, S&P 500 mutual funds are ubiquitous. And for that reason, it’s easy to get overwhelmed by the question, “which fund should I choose?”. So, here are a few things to keep in mind when trying to select an S&P 500 mutual fund:
✔️ Expense Ratio
This is the annual fees that mutual fund managers charge. It is expressed as a percentage of your investment. If it’s 0.1%, for instance, and you invest $10,000 you will be charged $10 in the course of one year, assuming the value of your investment doesn’t change.
This can heavily impact the performance of the fund over the long run, so the lower it is the better your returns will look.
This can heavily impact the performance of the fund over the long run, so the lower it is the better your returns will look.
✔️ Historical Performance
Mutual fund issuers will present their past returns on their websites. Focus on the long-term annualized returns of a mutual fund and compare them to those of competitors to gauge its historical performance.
✔️ Assets Under Management (AUM)
The assets that a mutual fund has under management can help you understand how much trust the public has in it. Usually, the older the fund, the larger the AUM and the more prominent the issuer will be considered.
Beyond the fact that the size of assets depicts a well-established mutual fund, it also helps with preserving low expenses. The expense ratio is not set in stone and managers have operational expenses they need to cover. Usually, the larger the fund, the lower the fees can be.
Beyond the fact that the size of assets depicts a well-established mutual fund, it also helps with preserving low expenses. The expense ratio is not set in stone and managers have operational expenses they need to cover. Usually, the larger the fund, the lower the fees can be.
Choosing top S&P 500 ETFs
DEFINITION
An Exchange-Traded Fund (ETF) is a fund that is listed on a stock exchange and is traded just like stocks.
Think of an ETF as a mutual fund that has listed its shares on a stock exchange and is traded between investors, just like a publicly traded company.
When you buy shares of an ETF, you indirectly buy the assets the ETF holds. But, unlike with mutual funds, there is another shareholder on the other side of the trade instead of the fund’s manager. That’s to say, if you buy the funds’ shares, another shareholder is selling you theirs.
Index ETFs do the same job as mutual funds that track the index. Buying one will buy you the constituents of the S&P 500. The difference lies in the structure. Because ETFs are essentially stocks, they have more liquidity. They can sometimes charge lower fees than mutual funds because of the more cost-efficient way of issuing and redeeming shares.
When selecting an ETF to track the S&P 500 index, you can examine what we listed above for mutual funds.
When you buy shares of an ETF, you indirectly buy the assets the ETF holds. But, unlike with mutual funds, there is another shareholder on the other side of the trade instead of the fund’s manager. That’s to say, if you buy the funds’ shares, another shareholder is selling you theirs.
Index ETFs do the same job as mutual funds that track the index. Buying one will buy you the constituents of the S&P 500. The difference lies in the structure. Because ETFs are essentially stocks, they have more liquidity. They can sometimes charge lower fees than mutual funds because of the more cost-efficient way of issuing and redeeming shares.
When selecting an ETF to track the S&P 500 index, you can examine what we listed above for mutual funds.
S&P 500 performance
You may be wondering how the S&P 500 has performed over all these years. Below is a chart that depicts its price change from 1982 to 2023:
S&P 500 index price performance (40 years)
Source: TradingView. Past performance is no guarantee of future results.S&P 500 vs Dow Jones (DJIA): Which index is best?
Both the S&P 500 and the Dow Jones Industrial Average (DJIA) are used as broad-market benchmarks. However, they have some differences.
The most obvious one is the number of stocks included in the index (known as constituents). DJIA tracks the performance of the 30 largest stocks in the United States, a far cry from the 500 stocks in the S&P 500.
The other significant difference you need to know is the methodology of each index. While the S&P 500 is market-cap-weighted, the Dow is price-weighted.
The S&P 500 will weigh a stock according to its market cap; the larger it is, the more weight it gets. Dow Jones weighs its stocks based on their price per share; the higher it is, the more weight a stock gets.
The most obvious one is the number of stocks included in the index (known as constituents). DJIA tracks the performance of the 30 largest stocks in the United States, a far cry from the 500 stocks in the S&P 500.
The other significant difference you need to know is the methodology of each index. While the S&P 500 is market-cap-weighted, the Dow is price-weighted.
The S&P 500 will weigh a stock according to its market cap; the larger it is, the more weight it gets. Dow Jones weighs its stocks based on their price per share; the higher it is, the more weight a stock gets.
Recap
The S&P 500 index is one of the most used indices as a benchmark. It tracks the performance of the 500 most profitable, large, and liquid stocks in the U.S., and for that reason, it’s ideal for index funds.
Investing in an S&P 500 index fund will provide you with more than adequate diversification while making it possible to closely mirror the performance of the broad market. There is a plethora of mutual funds and ETFs that will do the job at a relatively low cost.
Investing in an S&P 500 index fund will provide you with more than adequate diversification while making it possible to closely mirror the performance of the broad market. There is a plethora of mutual funds and ETFs that will do the job at a relatively low cost.
FAQ
Q: What is the S&P 500 in simple terms?
It is a measure of the U.S. stock market’s performance. It does this by tracking the price changes of highly liquid stocks issued by 500 large and profitable companies in the United States.
Q: What does S&P stand for?
“S&P” stands for “Standard & Poor’s”, which is a credit rating agency now called S&P Global Ratings. However, people talking about “the S&P” are usually referring to the index and not to the rating agency.
Q: Can I just buy S&P 500?
You cannot buy the S&P 500 because it’s an index; a way to measure the performance of the stock market. What you can do, instead, is to invest in an index fund or index ETF that tracks the S&P 500. Your performance will be very close to that of the index but not the same because of transaction costs and management fees.
Q: What makes up the S&P 500?
At any given time, the S&P 500 consists of 500 large-cap stocks that the index’s committee identifies as most representative of the US stock market. The composition of the index is rebalanced on the third Friday at the end of each calendar quarter to reflect any changes in the market capitalisation of the constituents and other stocks that qualify.
Q: Who is eligible for S&P 500?
The stocks that are eligible for the S&P 500 must be large-cap, highly liquid, and be issued by profitable companies.
Q: Can you invest in the S&P 500 if you are not American?
You can invest in S&P 500 index funds even if you’re not American. Trading 212 gives investors from the UK, Europe and beyond a way to invest in most major US stocks and ETFs.
- Market Cap (Market Capitalisation): The total value of a company’s outstanding shares, calculated by multiplying the share price by the number of shares. It helps investors compare the relative size of different companies.
- Trading Volume: The total number of shares bought and sold in a given period. High trading volume indicates strong market interest and liquidity, while low trading volume can lead to greater price volatility.
- Market-Value-Weighted Index: A type of stock index where each stock’s weight is determined by its total market capitalisation. Larger companies have a greater influence on the index’s movements compared to smaller companies.
- Float-Adjusted Weighted Index: A stock index weighting method that considers only shares available for public trading, excluding restricted or insider-owned shares. This approach aims to provide a more accurate reflection of the market.
