Friday, July 29, 2005

Large Cap Stocks And Index Funds

One of the most widely mentioned problems with index fund is that a few large cap stocks are allocated significant amount of money in the fund. The critics argue that a handful of large companies more or less determine the returns of the index fund. As is the case today, the ten largest companies in the S&P 500 index account for 20% or more in the index. The opponents of the market capitalization weighted index funds argue in the favor of equal weighted index fund where each holding is given equal weight in the index.

The top ten stocks of the S&P 500 index today are: GE, ExxonMobil, Microsoft, Citigroup, Pfizer, Johnson & Johnson, Bank of America, Wal-Mart, Intel, American International Group; in that order. These ten companies accounted for 21.1% of the S&P 500 index on 6/30/2005. The top holding GE accounts for 3.4% of the index fund holdings.

Now, Let’s examine GE closely.

You may not know this, but GE is actually a collection of 11 different business units working under the umbrella of the name General Electric. These 11 units are:
  • GE Advanced Materials
  • GE Commercial Finance
  • GE Consumer Finance
  • GE Consumer & Industrial
  • GE Energy
  • GE Equipment Services
  • GE Healthcare
  • GE Infrastructure
  • GE Insurance Solutions
  • GE Transportation
  • NBC Universal.

See for yourself. Now, that 3.4% of the index fund is actually made up of 11 different business units. Some of these businesses are multi-billion dollar businesses. So, if the GE was ever to spin-off its businesses in 11 individual companies, it will still account for 3.4% of the S&P 500 Index, all things being equal.

My point is that if GE (a collection of 11 businesses) takes up 3.4% of the index fund then there is nothing wrong with that. The index fund investors need to alter their thinking method. They should not to be afraid of the 3.4% weighting given to GE. They should not think that too much money is riding on a single horse. The 3.4% allocation is nicely divided among 11 business units underneath.

If you scratch the surface of the other remaining 9 companies (from ExxonMobil to AIG), you will find that they also do not do one single thing. These businesses are diversified under the surface. Please keep this in mind while investing.

All disclaimers apply.

3 comments:

David said...

GE is kind of an exceptional company--it is, as you point out, a collection of separate businesses, but it is at the same time more than a classical conglomerate.

I don't think the same kind of internal diversification applies at many other very large companies...I certainly don't see it at many of the others on the top-10 list.

Jose Anes said...

GE is almost an index fund due to all of its holdings.

MO (Altria / Phillip Morris) is not as widely diversified, but getting there. And their returns have been exceptional lately.


Money And Investing

Micro said...

GE is a great company and has a number of diversified businesses, BUT a major lawsuit, investigation, or even customer default could make GE behave like a single company.

Look at how Tyco fell when the scandal came out!

I am not at all suggesting that there is a scandal in GE or that there might be.

I will say that GE has a very complex set of financials to really understand. Sit down with the annual report and try to understand it.

Great Blog!

Themicrokid

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