As 2020 mercifully draws to a close, index investors will look back on the year as one they would rather not repeat. After climbing to new heights early in 2020, the stock market took investors on one of the wildest rides in its history – from the market peak to the bear market low, then back to new highs – all within nine months! If anything, this last year should serve as a stark reminder even to index investors of the impact extreme volatility can have on their portfolios and that they may not be as diversified as they think.
For many index investors, the key selling point for investing in an index fund is its ability to provide them with immediate and broad diversification. Conceivably, when you invest in the Standard & Poor’s 500 index via an index fund or ETF, you are buying a stake in each of the 500 companies in the index. But do investors really know what it means to invest in the S&P 500? Probably not because, if they did, they’d realize how vulnerable their portfolios are to extreme volatility and downside risk.
Why We Liked the S&P 500
The S&P 500 index is a popular benchmark because it ostensibly represents large-capitalization U.S. stocks as an asset class. Historically, investing in large-cap stocks is deemed less risky than investing in mid- or small-cap stocks because they tend to be more stable. The DJIA has long been considered the best market barometer of large-cap, blue-chip stocks. But, with just 30 stocks, the index doesn’t come near to capturing the price movements of a market that has well over 500 publicly traded companies with market values over $3 billion.
Most investors view the Standard & Poor’s 500 index as the better proxy because it more broadly represents the market with 400 industrials, 40 utilities, 20 transportation, and 40 financial institutions across 118 industry groups and eleven economic sectors.
Why We No Longer Like the S&P 500
More recently, even the S&P 500 index is being viewed as too small and incomplete, with a relatively small number of companies carrying too much of the index’s weight. Considering that, based on market cap weightings, more than 26% of the index is comprised of five of the largest tech stocks, the index is no longer as indicative of the market as investors may think. While tech stocks make up 26% of the index, energy stocks comprise only 3%, which means that what happens in the tech sector impacts the index eight times as much as what happens in the energy sector.
So, you shouldn’t be too surprised when the performance of the S&P 500 doesn’t match the underlying performance of the economy. During this economic downturn, energy stocks in the aggregate have fallen by more than half, but their weighting in the index is too small to move the needle. Yet, many of the tech stocks in the index have been benefiting from certain aspects of this economic crisis, and their overweighting in the index has been driving its performance.
Considering that 10% of the stocks in the index represent more than 50% of its total allocation and that the smallest 250 stocks (half the index) represent just 12% of the allocation, the S&P 500 may now be suffering from the same affliction as the DJIA. It is becoming too narrowly focused on too few stocks to adequately represent the universe of large-cap stocks.
The overarching problem with the S&P 500 index is in the way companies are selected as members. Essentially, a committee governs the composition of the index for the purpose of maintaining stability in the index’s make up. Because the committee adheres to a flexible approach to selection rather than a rigid set of rules, the makeup of companies is arbitrary and inconsistent. It’s supposed to be an index of the 500 largest companies, but it’s not. They may be among the largest, but the committee leaves out companies that don’t meet its other criteria.
That’s the reason why the S&P 500 committee, after excluding Tesla, one of the top ten companies in terms of market capitalization, for ten years, capriciously decided to add it to the index. In a scary sense, the biases of the S&P 500 committee members have more of an impact on the performance of the S&P 500 than the economy. What investor wants to rely on that?
Why We Like the Russell 3000 Index
That’s why, whether for investment or for measuring performance, investors should turn to the Russell 3000 index. Its rules for inclusion are straightforward and consistent so that the index does actually consist of nearly all of the 3,000 publicly traded companies in the United States today. The index is reconstituted annually on June 30, with all 3,000 companies ranked by total market capitalization. Their weightings are adjusted based on the investable portion of their holdings.
The bottom line is the Russell 3000 matches the S&P 500 on all the critical benchmark criteria but is superior in several ways, starting with its objectivity and consistency in its composition. It’s a purer form of indexing and much more indicative of what is actually going on in the market.
