The hidden drag of the S&P 500 that can reduce your returns

The hidden drag of the S&P 500 that can reduce your returns

Capitalization-weighted indices are popular. They give more weight to big companies. The S&P 500 is perhaps the most striking example. However, the researchers suggest that this type of index may underperform other weighting strategies. The question is why. Researchers from Intech and the London School of Economics believe they have the answer in a 2019 published in the Journal of Investment Consulting. This builds on original research by Rob Arnott and others in a 2013 Journal of Finance. This second article showed that if you weight stocks equally, at random, or in several other so-called naive ways, you would typically outperform a cap-weighted index, such as the S&P 500, over the long term. In this case, the long run is measured in decades. There are different ways of explaining why some so-called naïve portfolios tend to beat the S&P 500 over the long term, but perhaps the clearest explanation is better diversification. The S&P 500 places very heavy weight on just a few stocks. Currently Microsoft, Apple, Amazon, Facebook and Tesla account for about a fifth of the value of the S&P 500 while they only represent about 1% of the companies in the index. In a sense, these companies have twenty times more weight in the index than an equal weight would give them. This extreme overweighting could be seen as poor diversification, and poor long-term diversification can hurt performance. This isn’t to say that there is nothing wrong with including large cap stocks, but there is potentially something wrong with having too much of them in your portfolio. The price volatility of these big names does not necessarily cancel out with other stocks, given their large size, and remains a drag on the portfolio. Other methodologies for constructing indices are better diversified. Research clarifies this by proposing an even more concentrated weighting formula than the S&P 500. How does it work? It’s one of the few weighting methods that does even worse than the S&P 500 itself. So the other weighting methods don’t necessarily do anything particularly smart compared to the S&P 500, they’re just better diversified.

Highlights

  • According to Forbes “The hidden trail of the S&P 500 that may reduce your returns.”
  • Researchers from Intech and the London School of Economics believe they have the answer in a 2019 published in the Journal of Investment Consulting. This builds on original research by Rob Arnott and others in a 2013 Journal of Finance. This second article showed that if you weight stocks equally, at random, or in several other so-called naive ways, you would typically outperform a cap-weighted index, such as the S&P 500, over the long term. In this case, the long run is measured in decades.

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