As a Benchmark, the S&P 500 Just Doesn’t Stack Up

 

Let’s not mince words – for almost all investors, the S&P 500 Index is a terrible benchmark for their overall portfolio. Unfortunately, however, it tends to be the index that people are most familiar with and thus, the one they use. Each evening on the nightly news, the anchorman or anchorwoman will cast a broad summation of that day’s performance in the financial markets by citing the move in the S&P 500. For many, it’s the investment “barometer” that they see the most. This is likely a function of tradition as the S&P 500 Index was founded in 1957. At the time, large U.S. stocks made up the lion’s share of an investor’s assets and the performance of such was enough to pass judgment on the performance of one’s own portfolio. Over time, the S&P 500 became quite recognizable.

However, during the next 60 years, changes in the investment world have markedly changed an investor’s opportunity set. For example, an investor can now easily access a much larger variety of asset classes through the use of mutual funds or exchange-traded funds (ETFs). Despite this change in the make-up of investment portfolios, the S&P 500 and its strong recognition just stuck. In looking at it, the S&P 500 represents the largest 500 stocks in the United States. A quick analysis of that brief description alone is enough to realize that the index is clearly not built to measure the relative performance of a global portfolio allocated across multiple asset classes.

The index represents a collection of just stocks – not fixed income, not cash, and not alternatives. For everyone except maybe the most aggressive of investors, these are critical components of a well-diversified portfolio. Fixed income and cash provide downside protection in investors’ portfolios and provide the perfect counterbalance to much more volatile stock allocations. Moreover, alternatives have the ability to both mitigate risk and enhance returns.

Not only does the S&P 500 represent just a collection of stocks, it represents only stocks from the United States. Stocks from the rest of the world are completely excluded. As we’ve mentioned before, it is hugely important for investors to broaden their view and dedicate an allocation of their portfolio to stocks outside of the United States. Over the long haul, investors benefit from utilizing the most robust opportunity set. This is true because investments from different parts of the world are driven by different factors (growth rates, government policy, currency levels, valuations, economic activity, etc.).

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Lastly, not only does the S&P represent a collection of stocks from just the United States, it represents only the largest stocks from the United States. While it is true that the overwhelming majority of the U.S. stock market is made up of the country’s largest companies, a still significant portion is made up of the companies that don’t make that cut – so called mid- and small-cap stocks. These smaller offerings provide a slightly different risk-return profile than their larger brethren and, therefore, they more often than not make it into many investors’ portfolios.

It’s pretty easy to see that the S&P 500 suffers from a broadness problem. It is much too narrowly focused to be used to correctly evaluate the performance of a well-diversified portfolio.

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Let’s look at an example to see how using the S&P 500 as a yard stick may lead investors astray. Consider an aggressive investor with a portfolio made up entirely of global stocks. The chart below highlights annual performance over the past 15 years for domestic stocks (represented by the S&P 500 Index) and international stocks (represented by the MSCI ACWI Ex USA Index).

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As you can see, in some years, domestic stocks outperform and in some years, international stocks outperform. If the hypothetical investor above uses the (narrowly focused) S&P 500 to evaluate performance, he or she will identify periods of both outperformance and underperformance based purely on the direction of foreign stocks. He or she may also attribute this performance to the overall management of the portfolio, when in reality it is purely a function of improper benchmarking. It is important to make sure that the benchmark is representative of the portfolio’s overall exposure to ensure an “apples-to-apples” comparison.

At Nottingham, we believe all investors should monitor and track the performance of their portfolios. If they’re managing it themselves, it provides some much needed self regulation. If they’re using an advisor (like us), it provides a high level of accountability. We’d simply advocate for making sure you are using the right “yard stick” to measure performance. We believe investors should view performance in the context of multiple assets classes, particularly domestic equities, international equities, fixed income, and cash. The weight afforded to each asset class should be derived from an individual’s specific risk tolerance. In many cases, those managing portfolios for themselves will find that an appropriate benchmark often introduces an unpleasant dose of reality as previously thought outperformance turns out to simply be the spoils of a bad benchmark. For those with advisors, it provides a much more fair and accurate view to evaluate their success or failure.

So the next time you see the S&P 500 quoted somewhere in the national news, be it in print or on television, just remember that it’s only part of the story…

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