Defining the S&P 500: A Poor Benchmark for the Modern Portfolio

As 2014 came to a close, many investors were left wondering why their portfolios underperformed the S&P 500, which reached record highs and finished up 13.7% for the year.

Because the financial media provide constant updates on this index, many investors believe that it is an appropriate measure of investment success.  However, the typical investor’s portfolio often bears little resemblance to the index, as the S&P 500 only represents a single asset class: U.S. large cap equities.  A more suitable performance benchmark for the modern, diversified portfolio may be a weighted benchmark that proportionally represents all asset classes included in one’s portfolio.

The S&P 500 is comprised of 500 U.S. large-cap stocks, chosen because they are leading companies in leading industries within the U.S. economy. Each company in the index is weighted by its market capitalization, defined as share price multiplied by the number of shares outstanding.  As a result, larger, more mature firms have a greater impact on the index’s performance. For example, Apple represents about 3.4% of the S&P 500 by market capitalization, in contrast to being just 0.2% if it were calculated on an equal-weighted basis. In fact, just five stocks – Apple, Berkshire Hathaway, Johnson & Johnson, Microsoft and Intel – accounted for 20% of the S&P 500’s gains in 2014.

The S&P 500 is an appropriate benchmark for a portfolio consisting of all U.S. large cap stocks, as the index represents about 72% of the value of the overall U.S. equity market. However, investors often use the S&P 500 as a measure of broad market performance, despite the fact that it represents only a small segment of the global financial market. In fact, the S&P 500 represents less than 30% of the global equity market, which is only one-third of the size of the global fixed income market. Investors must therefore look elsewhere to gauge portfolio performance given exposure to asset classes such as non-U.S. equities and bonds.

When investing in multiple asset classes, a portfolio’s overall benchmark should be a proportionally weighted blend comprised of the relevant indices that represent each included asset category. For example, a portfolio consisting of one-third U.S. large cap stocks, one-third U.S. bonds and one-third international stocks would be compared to a benchmark comprised of one-third S&P 500 Index, one-third Barclays U.S. Aggregate Bond Index and one-third MSCI EAFE Index. While the S&P 500 returned 13.7% in 2014, this blended benchmark returned only 3%. The blended benchmark method allows for an accurate, apples-to-apples comparison of total portfolio performance, and provides a more relevant measure of market performance for most portfolios.

Focusing on one index is often misleading, misrepresentative and can contribute to a larger and more problematic issue for most investors, namely, home bias. Despite the well-documented benefits of international diversification, many investors prefer to focus on well-known U.S. companies that they can easily see and follow. However, owning a portfolio comprised of a single asset class will likely lead to sub-optimal risk-adjusted returns.  Historically speaking, 2014 was highly unusual in that the S&P 500 drastically outperformed the rest of the global financial markets. Over the past 20 years, the S&P 500 has outperformed all other major asset classes only six times, and it was the worst performing asset class five times. So far in 2015, markets are proving the value of diversification. At the time of this writing, developed international equities, as measured by the MSCI EAFE Index (up 10.9%), and emerging market equities, as measured by the MSCI Emerging Markets Index (up 4.5%), are both outperforming the S&P 500 (up 3.2%).

In the long run, disciplined investors who ignore short-term market fluctuations and maintain well-diversified portfolios tend to outperform their benchmarks.  While it is important to use a weighted benchmark to judge a portfolio’s performance, investors should keep in mind that the true measure of investment success is the achievement of their unique financial goals and objectives, not the outperformance of indices in the news.  If you have specific questions about your portfolio, please contact your Andersen advisor.