Opinion: Why the S&P 500 Is Missing the (Bench)Mark

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There are many indexes quoted around the world, but sadly today some of the most widely used are becoming less and less helpful.

The Dow Jones Industrial Average is one of the oldest and most often cited indexes, which to us is genuinely remarkable given how little use it is as either a performance benchmark or as a representation of markets. The Dow is a manually selected index of 30 companies, handpicked by a committee, which comes with some fairly obvious conflicts of interest and biases. But the biggest failing of the Dow is that it is a price-weighted index. 

Since the growth of passive investing, indexes have morphed from simple yardsticks into hugely profitable products.

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That means a stock with a share price of $1,000 will have 10-times more weight in the index than a stock with a share price of $100, which makes little sense given that share price tells you nothing about the size or value of a company, as share price is only one half of the equation, the other being how many shares exist.

For a real-life example of how unhelpful price-weighting is, consider the time Apple underwent a stock split of 4 for 1 in 2020. Its weight in the Dow instantly dropped by 75% due to the new lower share price, because there were now 75% more shares. Was Apple suddenly three-quarters less important or influential as a company than it was the day before? Of course not.

Better but flawed. Compared to the Dow, the S&P 500 is a much better index. It is weighted by market capitalization, which incorporates both share price and number of shares, and it represents the 500 largest companies on that metric. The Nasdaq 100 Index follows the same methodology but is focused on 100 handpicked tech stocks. Given the S&P 500’s better weighting methodology and larger breadth, it’s of little surprise that it has grown to be the most widely used. But in our view, over the years the S&P 500 has become less representative of the U.S. economy, increasingly risky and less helpful as a performance measurement tool.

Indexes were originally created to represent the overall market. But since the growth of passive investing, which uses the index as the investment portfolio, indexes have morphed from simple yardsticks into hugely profitable products. Index owners earn fees on assets and funds that track their indexes. Today there are trillions of dollars in ETFs and funds that track the S&P 500, generating hundreds of millions of dollars in revenue for S&P Global each year.

The S&P 500 index is today controlled by an internal committee of S&P Global employees, which has ultimate discretion over company inclusion or exclusion, as well as sector allocations. It has  a clear incentive to ensure the index remains attractive to investors. After all, if investors think the S&P 500 is too risky they might instead buy an ETF linked to a Russell or MSCI index, which would mean lost revenue for S&P Global.

Diverse how?  So when a single sector like technology doubled in size over a decade, as it did recently, going from 18% 10 years ago to almost 40% today, that can lead to investor concern over risk and lack of diversification, potentially causing investors to move to other indexes. In 2018, S&P Global created a new sector called Communication Services, into which many of the technology names were moved, thus dropping the overall technology weighting of the S&P 500. At the time, the justification for this change was to reflect the changing economy, but it also had the effect of making the S&P 500 look more diversified and therefore less risky to investors, even though one could argue that the real exposures (and therefore risks) remained entirely unchanged.

Then, there is the S&P 500’s utility as a performance comparator to consider. Many investors have noted how much the S&P 500’s valuation has fallen in recent months and how its multiple today compares to periods of previous drawdowns. But these comments are meaningless due to the fact that the composition of the S&P 500 changes hugely over time,  both in sector terms but also in individual company terms (this is also the case with most indexes). The S&P 500 five or 10 years ago was vastly different than it is today, so comparing index multiples across time periods is comparing apples and oranges.

Finally, we are all consistently told that diversification reduces risk. But as a firm, we believe that indiscriminate diversification is an ineffective tool toward this end. Fundamentally, we believe it is far less risky to own 20 companies that you are very confident in than to own 500 you know nothing about. Blindly holding a large number of popular stocks isn’t usually the best way to protect a portfolio. The best way to control risk is to know what you own.

What’s the solution? Benchmarking investment performance is an inherently difficult task, and one that doesn’t look to be getting any easier. It could be worth considering broad market returns, absolute long-term returns, and even relative returns between similar strategies. As is usually the case in investing, there is no black and white answer.

Guy Davis, CFA, Managing Director and Portfolio Manager at GCI Investors

Photo Illustration by Barron’s Advisor

Guy Davis is the managing director and portfolio manager of GCI Investors, a U.S.-based independent asset manager that runs a concentrated, fundamentals-focused portfolio available as an active ETF, The Genuine Investors ETF. He and his team are prolific writers and commentators on financial markets, individual companies and investment practices. He is also the co-author of “Navigating the Street: A Better Approach to Investing.”