Is the S&P 500 still a relevant benchmark? That depends.
Large-cap U.S. equity funds in 2020 underperformed the S&P 500 for the 11th consecutive year, based on data from S&P Global. On the surface, these results suggest that there is a need for a washout — i.e., where some percentage of the underperforming funds close up shop — but we believe this is an overly simplistic conclusion.
Critically, we are not seeing the same sustained underperformance — vis-avis their respective benchmarks — for large-cap growth funds or large-cap value funds. Over the past 10 years, large-cap growth funds have outperformed their benchmark 60 per cent of the time and largecap value funds have beaten theirs 30 per cent of the time. In contrast, large-cap core funds have trailed the S&P 500 in each and every year over this period. Given these results, we see only three possibilities that can explain this divergence.
One possibility is that large-cap core fund managers have just been extremely unlucky and are poised for better results going forward. The second possibility is that these managers are, on average, less skilled than their counterparts in growth- and value-oriented funds. The third possibility is that these managers are using the wrong benchmark to measure their performance.
Of the three explanations, we consider the third the most likely. Given the exceptionally strong performance of the technology sector in particular, there is little doubt that the S&P 500 has become increasingly growth oriented in recent years. The tech sector made up more than 27 per cent of the S&P 500 (as of the end of June), which is the highest weight since the tech bubble. Conversely, financials, a classic value-oriented sector, have shrunk to 11 per cent from a high of 22 per cent in late 2006.
Note that the difference in performance between these two sectors (financials less technology) almost exactly tracks the Fama/french Value factor (see accompanying chart). This further reinforces how the shift towards technology (at the expense of financials) has de facto made the S&P 500 more growth oriented than in the past.
As a result, unless managers are taking on similar, or greater, technology weights (versus the S&P 500), they are, in effect, making their portfolio more value oriented. This has not been a winning strategy in recent years.
According to an analysis by Morningstar (What’s Driving U.S. Stock Fund Returns?), “funds with holdings that displayed stronger growth characteristics significantly outperformed those with a value tilt.” Morningstar added that “this trend also played out within growth stock categories, as the ‘growthiest’ funds outperformed those with even a slight tilt toward blend or value.”
In other words, having disproportionate growth exposure has been a winning strategy, whereas value tilts have led to inferior performance.the problem is the average U.S. equity fund has been underweight growth in recent years. For example, in August 2020, the average fund (according to Morningstar data) held 29 per cent in two sectors: technology and communication services (which includes Alphabet Inc., Facebook Inc. and Netflix Inc.). This may seem like a lot until one compares this weight to the S&P 500: these sectors made up 40 per cent of the index at the time. The average U.S. equity fund, therefore, has had a value tilt (versus the S&P 500), which can at least partly explain their inferior performance.
Instead of using the S&P 500 as a gauge of performance, these managers would be better off picking a benchmark that has a similar style. To provide some suggestions, we examined some of the more popular indexes. We then regressed their monthly returns against the three Fama/french factors: value, size and market risk. For the purposes of this analysis, we are most interested in the coefficient in front of the value factor: the larger the coefficient, the stronger the value/growth tilt versus the so-called market portfolio (which is just the U.S. equity universe). Note that a positive coefficient denotes a value tilt, whereas a negative coefficient implies a growth tilt.
The results showed that the S&P 500 Pure Value Index has the greatest value exposure whereas the Nasdaq Composite has the largest growth exposure (even more than the S&P 500 Pure Growth Index). For large-cap managers, the S&P 600 and S&P 400 obviously won’t be relevant benchmarks (due to their size), which leaves the NYSE Composite, S&P 500 Equal Weight Index, Dow
Jones Industrial Average and the S&P 500 Dividend Aristocrats as other options with slight value dispositions.
However, the NYSE Composite is made up of stocks of varying sizes, so it doesn’t make sense for large-cap managers to compare their performance to. In addition, the index construction of the Dow Jones Industrial Average makes it problematic to use: comparing a price-weighted return (DJIA) to a value-weighted return (portfolio) is not apples to apples. This leaves the S&P 500 Equal Weight Index and the S&P 500 Dividend Aristocrats as two solid choices for potential benchmarks.
This is not to say the S&P 500 is a flawed benchmark — far from it. As evidenced by the tiny (and insignificant) coefficient in front of the Fama/french value factor, its style (in terms of its growth versus value exposure) is entirely representative of the market portfolio. Put differently, the S&P 500 has indeed become more growth oriented due to its shift towards technology, but so, too, has the U.S. equity market in its entirety. The same can be said of the Russell 3000 and Wilshire 5000, which is not at all surprising since they respectively represent 98 per cent and 99 per cent of U.S. securities by market capitalization.
Yes, the S&P 500 is still a relevant benchmark for large-cap U.S. equity managers without a value or growth tilt (versus the market portfolio) to their fund. But, the more managers deviate from this style, the less relevant it becomes for measuring performance. As such, managers that are overweight value stocks might want to consider the S&P 500 Equal Weight Index or the S&P 500 Dividend Aristocrats as potential benchmarks. These indexes are likely more representative measures of performance and can thus better inform investors about a fund’s ability to add alpha.