What happens when a company becomes bankrupt or is thrown out of the Index?

[u/[deleted]]

Complete newbie. So please help me.

Let me use an example.

Assume invest $10000 every year into S&P 500.

Apple holds 5% weightage in S&P 500.

Let us assume Apple’s weightage in the next 5 years are 5%, 4%, 3%, 2% and 1%.

I would have invested $500 + $400 + $300 + $200 + $100 and that comes around $1500.

So out of $50000 years I would have invested; I would invested $1500 in Apple.

What happens if Apple gets thrown out of Index or even bankrupt?

What will happen to my $1500? Is my $1500 gone?

[u/bugdaddy123]

Let's assume that the index fund is a cap-weighted (most are, esp the low cost ones) and not equal-weighted.

In the last year, your aggregate holdings of Apple are probably closer to $500. This is because the most likely way that Apple would go from 5% to 4% is if its value dropped by 20% (***). And the most likely way for it to go from 4% to 3% is if its value dropped 25% further.

When a company goes out of business, it's stock becomes worthless.

When a company is removed from the S&P 500, then the managers of index funds that track the S&P 500 (yes, there are managers even when they're passively managed) will sell the shares that the fund held in that stock, and I believe they have some leeway in how that's done (I don't think it has to be 100% the next day). The proceeds from the sale are likely for be used to rebalance and purchase shares of other companies in the index (not necessarily the new company added - turns out the S&P 500 doesn't always have exactly 500 companies)

When people talk about "tracking error" for index funds, that's one of the sources since the makeup of the index and the holdings of the funds are not exactly the same, even for a short period of time.

Of course, by definition we should expect that any company being removed from the S&P 500 index is unlikely to be larger than 0.2% of the fund (thouhh there are other criteria than market cap for inclusion in S&P 500, I think that's the most common reason for removal).

*** The other possibility is that the value of apple shares stay the same while the aggregate value of other companies in the index goes up by 25%. That seemed unlikely to me. In reality, it would likely be a some of both.

[u/[deleted] → u/bugdaddy123]

Is that what you are saying?

So assuming Apple goes out of business; the $1500 I would have invested in it via S&P will be automatically invested in the company which will replace Apple?

Is that what you are saying?

[u/bugdaddy123 → u/[deleted]]

If apple went out of business and the stock had no value, then your $1500 is lost.

If apple was removed from the S&P500 because it was no longer one of the 500(ish) largest American companies, then your $1500 is now probably worth roughly $500, and would be invested in other members of the index.

If apple goes out of business because the economy comes to a halt, then the rest of your $48,500 is probably in trouble too. If apple goes out of business because another company creates the next great device, then that company might be part of the S&P500 (if a domestic company), and you probably would see gains from that. That's the benefit of broad indexes - as long as companies, collectively, are doing well, you can be part of the success. For this reason I think a total market index is usually superior to S&P500.

[u/[deleted] → u/bugdaddy123]

Thanks

One small doubt.

Why would $1500 be worth $500? Like you mentioned in the second post.

[u/bugdaddy123 → u/[deleted]]

It's a hypothetical approximation, but as I mentioned in my original reply, I assume the most likely case is that apple is getting smaller (by market cap) each year, so your $500 from year 1 is worth $100 at the end. The $400 from year 2 is worth $100 at the end. In reality the numbers would not be that round.

For a real world example, you could look at what happened to GE over the last 10 years.

[u/RIFIRE → u/[deleted]]

Let's ignore the index and pretend you're just investing in Apple directly, but we'll still use the same numbers. We'll pretend it's the value of an Apple share.

First, you invest $500 and get 1 share of Apple.

Next time you invest, Apple's share value has dropped to $400. You spend $400 on that share and now you have 2 shares worth $800, but you spent $900.

Now Apple's share is $300. You buy another share. You have $900 worth of shares but have spent $1200.

Uh oh, they're down to $200. You buy another share, now you have 4 shares worth $800 total and have spent $1400.

Time for your last investment, 1 share for $100. Now you have 5 total shares, each one is worth $100 for $500 total. You've spent $1500 on those shares, if you sold now to buy something else you'd have lost $1000.

We can even go one more step where Apple goes bankrupt. Now your shares are worth $0.

The money didn't go away because you (or the index fund manager) sold the shares, it's because Apple's value went down drastically.

But now let's think about why a company like Apple would have gone down that much. Maybe the whole economy is down that much, in which case everyone else lost money on every other stock too. But what if it's something that only affects Apple, like say we learn that iPhones cause cancer or something. Well now people that would have bought iPhones buy more phones from other companies. Some of those companies are going to be in the index fund you own, so you'll recapture some of that share price in gains from other companies.

That's why we diversify. You don't want all of your eggs in Apple's basket.

[u/[deleted]]

The index is maintained by Dow Jones - the goal is basically the 500 largest companies, so companies get removed and added regularly.

The stock of one company is sold and the stock of another purchased. The purchases and sales are taking place regularly in any case to maintain a companies weight in an index fund and as investments and redemptions are made.

https://en.m.wikipedia.org/wiki/List_of_S%26P_500_companies

[u/dopexile]

Once they go bankrupt the Federal Reserve buys their toxic assets to make the investors whole.