A tale of two indices

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December 9, 2020
 

Launched in 1957, and largely considered a gauge for the US economy, the S&P 500 Index is one of the most popular large cap indices with over $11.2 trillion in assets benchmarked against it.1 However, the Morningstar US Large Cap index has been gaining traction in recent years. What are some of the differences?

Index construction

The Morningstar US Large Cap Index is comprised of the top 70% of eligible companies by market capitalization. To make it into the index a security must meet certain criteria surrounding liquidity, geography and size.2 Similarly, the S&P 500 is a rules based index, in the sense that it has a market value a company must exceed before becoming eligible; companies have to be “highly” liquid; and their most recent quarter’s earnings, as well as the sum of their trailing four consecutive earnings must be positive.

However, one major difference is that while Morningstar’s security inclusion methodology is primarily rules based, the S&P 500 places the fate of its final decisions in the hands of a committee.

The Index Committee, which meets monthly, is comprised of full-time staff of S&P Dow Jones Indices. At each meeting, the group reviews potential candidates for inclusion, significant market events and corporate actions that can affect constituents, among other topics. It can also revise the rules by which companies are selected.3 This can make a difference in quite a few areas. So, while companies must solely jump through quantitative hoops to make it into Morningstar’s index—for the S&P 500, although there are rules, stocks are ultimately added at the discretion of its Index Committee.

Another difference is the way the indices are rebalanced: the Morningstar US Large Cap Index is always rebalanced quarterly while the S&P 500 is sometimes rebalanced quarterly, but can deviate from this schedule, depending on whether the Index Committee calls for an exception.

The Morningstar US Large Cap Index offers a degree of flexibility in other aspects of its process. For instance the number of securities, which comprise the index (191, as of the start of November 2020), varies over time to reflect changing market dynamics like consolidation of the universe or expansion, whereas the S&P 500 tops out at 500 companies (505 stocks since a few companies issue multiple classes of shares).3 Generally, for a new security to be added to the S&P 500, a merger or acquisition must take place to make room.3

“It’s important to recognize the varying benchmark methodologies that different index providers employ that will inform how an index is ultimately constructed,” says Stephanie Hill, Head of Index at Mellon. “A benchmark with flexibility on number of securities allows it to capture the target market cap range over dynamic market conditions. Investors ultimately want to know that they are getting the beta to the market regardless of how the market is performing.”

Since both indices are market-cap weighted, meaning the largest companies receive the largest positions, their top 10 looks identical. However, there is divergence beyond the top 10, which can impact performance between the two.

Composition

Some of the key differences in broader exposure has to do with the sector composition between the two. Notably, the Morningstar US Large Cap Index is overweight information technology compared to the S&P 500, due to larger positions in both Apple (7.69% vs 6.45%)4 and Microsoft (6.73% vs 5.65%), and the communications services/telecommunication sector, due to overweights in both Facebook (2.78% vs. 2.33%) and Google (4.22% vs 3.54%). While the two indices are closely matched in terms of overall exposure to consumer cyclicals, the Morningstar US Large Cap Index is significantly overweight in a couple of key stocks: Tesla, which was added to Morningstar’s large cap index in 2013 but is not yet included in the S&P 500,* and Amazon (5.68% vs 4.77%).

Other compositional nuances include Morningstar’s large cap index being slightly underweight, utilities, energy and industrials in comparison to the S&P 500. Also, the Morningstar index has a larger tilt toward companies considered giant market capitalization, while the S&P 500 has greater mid cap representation.

“We selected Morningstar as our benchmark provider when launching our initial ETF equity products because of the significant experience they bring building and delivering quality benchmarks, matched with significant marketplace recognition,” says Stephanie Pierce, Chief Executive Officer of BNY Mellon Investment Management ETF, Index, and Cash Investment Strategies. “We believe an established benchmark provider delivers core benchmarks that align with our clients’ typical strategic asset allocation plan. And Morningstar is one of the best in the industry—well-respected by clients and a very strong partner to us.”

The Morningstar index’s overweights in key areas and specific stocks described above are partially responsible for the discrepancy in performance between it and the S&P 500. In fact, over a three-year period ending 10/31/2020, the Morningstar US Large Cap Index outperformed the S&P 500. It has also outperformed the S&P 500 year-to-date, as well as over one and five-year periods.5

*As referenced in an article earlier this year by Stephanie Hill, Head of Index at Mellon, one of BNY Mellon Investment Management’s investment firms, Tesla has been the subject of much speculation as to when it will be added to the S&P 500 Index. It was announced on November 16, 2020 that the stock will be added to the S&P 500 Index on December 21, at which time it will become one of the S&P 500’s 10 most valuable companies. The security, which will be removed, to make room for Tesla is to be announced closer to the rebalance date.6

1 CNBC: Tesla Stock jumps on carmaker’s addition to the S&P 500. November 17, 2020.

2 Morningstar: Why do Morningstar Indexes include Tesla. November 10, 2020.

3 S&P Dow Jones Indices: S&P US Indices Methodology. Accessed November 2020.

4 All security weightings are as of 10/31/2020.

5 Morningstar Direct. Accessed November 2020.

6 Yahoo finance: Tesla is getting added to the S&P 500, shares surge on the news. November 16, 2020.

 

DEFINTIONS

S&P500 Index: A stock market index that measures stock performance of 500 large companies listed on the stock exchanges in the United States.

Morningstar US Large Cap Index: A stock market index that tracks the performance of U.S. large-cap stocks that represent the largest 70 percent capitalization of the investable universe.

Beta: Correlation to the overall market.

Overweight: An outsized investment in a particular asset, asset type or sector within a portfolio or index.

Underweight: A lesser investment in a particular asset, asset type or sector within a portfolio or index.

Investors should consider the investment objectives, risks, charges and expenses of a fund carefully before investing. To obtain a prospectus, or a summary prospectus, if available, that contains this and other information about a fund, contact your financial professional or visit im.bnymellon.com/etf. Please read the prospectus carefully before investing.

ETFs trade like stocks, are subject to investment risk, including possible loss of principal. The risks of investing in the ETF typically reflect the risks associated with the types of instruments in which the ETF invests. Diversification cannot assure a profit or protect against loss.

ETF shares are listed on an exchange, and shares are generally purchased and sold in the secondary market at market price. At times, the market price may be at a premium or discount to the ETF’s per share NAV. In addition, ETFs are subject to the risk that an active trading market for an ETF’s shares may not develop or be maintained. Buying or selling ETF shares on an exchange may require the payment of brokerage commissions.

Equities are subject to market, market sector, market liquidity, issuer, and investment style risks to varying degrees.

Small and midsized company stocks tend to be more volatile and less liquid than larger company stocks as these companies are less established and have more volatile earnings histories.

Past performance is no guarantee of future results. Indexes are unmanaged and one cannot invest directly in an index. The fund is not sponsored, endorsed, sold or promoted by Morningstar, Inc. (index provider) and the index provider makes no representation regarding the advisability of investing in the fund. The index provider determines the composition of the index and relative weightings of the securities in the index, which is subject to change by the index provider.

This material has been distributed for informational purposes only and should not be considered as investment advice or a recommendation of any particular investment, strategy, investment manager or account arrangement. Please consult a legal, tax or financial professional in order to determine whether an investment product or service is appropriate for a particular situation.

Views expressed are those of the author stated and do not reflect views of other managers or the firm overall. Views are current as of the date of this publication and subject to change. The information in this presentation is based on current market conditions, which will fluctuate and may be superseded by subsequent market events or for other reasons. The companies mentioned should not be considered recommendations to buy or sell a security. Mellon is a global multi-specialist investment manager dedicated to serving our clients with a full spectrum of research-driven solutions. Mellon Investments Corporation (Mellon) is a registered investment adviser and an indirect subsidiary of The Bank of New York Mellon Corporation.

BNY Mellon Investment Management is one of the world’s leading investment management organizations and one of the top U.S. wealth managers, encompassing BNY Mellon’s affiliated investment management firms, wealth management organization and global distribution companies. BNY Mellon is the corporate brand of The Bank of New York Mellon Corporation and may also be used as a generic term to reference the Corporation as a whole or its various subsidiaries generally. BNY Mellon ETF Investment Adviser, LLC is the investment adviser and BNY Mellon Securities Corporation is the distributor of the ETF funds, both are subsidiaries of BNY Mellon. No part of this material may be reproduced in any form, or referred to in any other publication, without express written permission.

©2020 BNY Mellon Securities Corporation, distributor, 240 Greenwich St., New York, NY 10286.

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