Ted Bauman Blog | The Smarter, Safer Gains You’re Missing | Talkmarkets
Editor, The Bauman Letter
Contributor's Links: Banyan Hill Publishing

Ted Bauman joined Banyan Hill Publishing in 2013 and serves as the editor of The Bauman Letter, Plan B Club and Smart Money Alert, specializing in asset protection, privacy, international migration issues and low-risk investment strategies. He lives ... more

The Smarter, Safer Gains You’re Missing

Date: Tuesday, November 7, 2017 11:20 AM EST

“What’s the stock market?”

If you’ve ever had a kid, you’ll know my preteen daughter wanted an answer now. Not three seconds from now. NOW.

Under such enormous pressure to impart professional expertise to my offspring, I told her it’s where people buy and sell shares in companies. Inevitably: “What’s a share?”

Eventually she had interrogated me to her satisfaction. But now I had questions.

Every day, I use the S&P 500 as a shorthand for “the stock market.” Like most major indexes, the S&P 500 is weighted by the value of each company’s total shares outstanding. That means it assigns a proportionate weight to each of its constituents with giants like Apple Inc. (Nasdaq: AAPL) having the greatest influence on the index.

But why, Daddy?

The reality is that an index-based exchange-traded fund (ETF) using market-cap weighting is a highly concentrated portfolio of ultra-mega-cap companies. In traditional S&P 500 ETFs, like the SPDR S&P 500 ETF (NYSE: SPY), Apple’s 3.89% weight is larger than the bottom 100 components combined.

That means SPY, or any other traditional index-tracking ETF, is skewed toward moves in mega-cap stocks.

Why should we consider that top-down approach to be “the stock market?” And what would happen if we didn’t?

Playing With Weights

Over the past decade, investors have been pouring money into index-based ETFs. These typically hold the stocks in the underlying index, ranked by their size.

But did you know that most of the time, the largest stocks tend to perform worse than the average stock in their sector? Historically, the biggest firm in any given sector underperforms the average stock in that sector by 3.5% a year over time.

Scaled up to the level of an entire index, that discrepancy means you might be missing a lot of gains if you stick with plain-vanilla ETFs like SPY.

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