By: Richard Feldman, CFP, MBA, AIF
When benchmarking a portfolio or asset class investing investors have multiple indexes they can use. But which index is most applicable? You have indexes from Standard & Poors, Dow Jones, Wilshire & Associates, MSCI, Lehman Brothers, Russell & Co. and many more. The S&P 500 index typically serves as the barometer for individuals to compare their investment results against. What individuals may not realize is that out performance or under performance of any index may have little to do with stock selection and more to do with how the index is actually constructed.
The broadest based index of domestic large companies is the S&P 500. The 500 stocks in the index are selected by Standard and Poor’s committee based on the company’s representation of the U.S. economy, stable financial profile, and liquidy (high level of trading activity). The S&P 500 is a market-weighted index, as opposed to an equal-weighted or price weighted index like the Dow Jones Industrial Average. This means that the S&P 500 gives each stock a weight that is in proportion to the market value of the company versus the entire index. For example, if the market capitalization of all stocks in the index is $20 million and an individual stock had a market capitalization of $1 million than that stock would comprise 5% of the index’s weighting.
The Dow Jones Industrial average uses a different methodology than the S&P 500. The DJIA uses a price-based weighting rather than a market cap weighting. The 30 stocks comprising the DJIA are weighted according to price, the higher the price, the heavier a stock’s weight. Assume that the sum of each stock in the DJIA is $1,000, a stock trading at $50 would comprise 5% of the index.
Equal Weighted Index
An equal weighted index can be constructed using the stocks in the S&P 500. Rather than weighting each individual stock based on market capitalization the weights are derived by dividing each individual stock by the number of total stocks. Each individual security in an equally weighted index based on the S&P 500 would have .2% of the index. (1/500 = .002%)
The same index can have dramatically different rates of return based on how the index is constructed. For example, Rydex has developed an ETF based on the S&P Equal Weight Index (Ticker: RSP) that has had superior investment results in comparison to the market weighted S&P 500 Index since being launched in May of 2003.
|May 03 – Mar 05|
|S&P 500 Index||Rydex S&P Equal Weight|
|Growth Of $1||1.33||1.52|
|Monthly Standard Deviation||2.45||3.33|
|Monthly Average Return||1.28||1.89|
|Annualized Stand Deviation||8.48||11.53|
Source: DFA Returns & Morningstar
The question is why has an equal weighted S&P 500 index thoroughly outperformed a market weighted index since May of 2003? The answer lies in the methodology of the index construction itself. The market weighted index has 27.15% of it’s assets invested in the top 15 holdings of the S&P 500 with General Electric being the largest contributor at 3.41%. In essence stocks with the largest market capitalizations carry the largest weighting and large capitilization stocks have underperformed over the past few years. In contrast the equal weighted offering from Rydex has a much greater allocation to the midsize and smaller companies located in the S&P 500. If you were to do a style attribution analysis on the performance of a market cap weighted S&P 500 fund you would be looking at a domestic large cap blend investment. Performance attribution analysis on an equal weighted S&P 500 fund would reveal that 70% of the performance is most similar to that of a mid-cap value style manager.
The market cap weighted S& P 500 outperformed an equal weighted index from 1995 – 2000 when the S&P 500 Index was generating annual returns in excess of 20%. Large Cap equities dominated the marketplace in that time frame and the market weighted S&P 500 index benefited greatly by having the greatest weightings on those companies.
Measuring index performance or benchmarking a portfolio is extremely difficult. When choosing an index to invest in or benchmark a portfolio against make sure the structure of the index is applicable to the portfolio you are trying to build. Index results can vary widely based on the structure of the composite. As you have seen above you might think that you are making a large cap investment when in reality you might be adding more mid cap value exposure to your portfolio.
Actively managed funds are guilty of making apples to oranges comparisons all the time. The reason is what is commonly referred as “style drift”. Typically active managers who have a large cap mandate will delve off into other asset classes such as Mid Cap and Small Cap equities in hopes of increasing portfolio returns and beating their stated index. In reality the comparison to the S&P is not really relevant given the fact that a portfolio may have drastically different structure than the S&P 500.