The S&P 500 Index
was first introduced on March 4, 1957, after being designed to serve as
a benchmark that would measure performance of the U.S. stock market.
Today, more than 50 years later, it is not only the most widely followed
measure of the markets, but also the most widely held investment vehicle
in the U.S. Of the $6 trillion currently invested in the U.S. markets,
$1.2 trillion is in the S&P 500.
But what exactly
is the S&P 500 index? The companies within the index, all large cap
companies, make up 75% of U.S. market capitalization. In 1957, at the
time of its introduction, the materials (e.g. steel, aluminum, mining)
and energy sectors made up almost half of the index’s value, while the
areas of technology, healthcare and financial services sectors were only
6%. Today, however, those numbers have switched. Technology, healthcare
and financial services are closer to half of the index’s value, while
materials and energy are a meager 12%. Sector allocation within the
index has drifted over the years as certain sectors figure more
prominently in the economy and are subsequently weighted more or less
heavily.
The index itself
is market-value weighted, which means that each stock’s weight is
proportionate to its market value. So, for example, Exxon, as the
index’s number one stock, can move the index more based on its
performance than a company further down the list.
In honor of the
index’s birthday, many a journalist stepped forward to sing its praises.
One was Wharton School professor Jeremy Siegel, who co-authored an
article in The Wall Street Journal entitled “Many Happy Returns.”
In it, he mentions that someone who bought all 500 companies listed in
March 1957 and held them over the past 50 years would have beat the
index itself, and also most professional money managers who try to beat
it. The article closes out by saying, “Happy Birthday S&P 500. You have
certainly aged well.”
Mr. Siegel’s math
is surely accurate, but perhaps his benchmarks set the bar a bit too
low. After all, is it hard to beat the S&P 500 Index and most money
managers? Let’s take a look at some numbers.
From March 1957
through February 2007, the S&P 500 has earned 10.77%. It’s true that
among money managers with a 15-year track record, only about one-third
of domestic mutual funds have beat the index. However, for those who did
manage to ride the S&P 500 to 10.77% return (or better), the risk is
higher due to a lack of diversification. What would happen, one
supposes, if just a bit of diversification was added to the mix?
Over the same time
period (the last 50 years), look at some other asset classes. Small cap
returned 13.08%, large value returned 13.88% and small value companies
returned 17.71%. Put dollars to those figures and you’ll see that $1 in
the S&P over the last 50 years would have turned into $166. However, the
same $1 would have become $3,475 in small value stocks.
Let’s look at it
another way. Say you put half of your money into the S&P 500 and half of
it into small cap stocks. Your 10.77% return from the S&P alone would
become 12.22%. Or $1 would become $318, rather than the $166 you’d earn
with just the S&P.
Then let’s go one
step further. Take 25% from each of those groups (S&P 500 and small cap)
and put it into value stocks. Your return grows to 14.11%, or $733. A
little diversification gets you much more return with much lower risk.
And that doesn’t even factor in some of the other key asset classes,
such as international or emerging markets. Now how many mutual funds do
you suppose could come up with better than a 14.11% return? Over the
last 15 years, only 3.6%, or 102 of the 2,766 funds that can be tracked,
beat what our hypothetical portfolio returned during the same time frame
and most of those 102 were small cap funds.
That’s a pretty
strong argument for diversification. In order to be properly
diversified, investors must move beyond the S&P 500 Index. It was fine
in 1957, but it makes no sense now for asset class investors. So has the
S&P 500 aged well, as Mr. Siegel indicates? Not really. It continues to
be outdone by the market return approach that owns the entire market,
bringing with it better long-term return with much lower risk.
