Many people assume that the S&P 500 is the actual US market. It is not. It just happens to be one of the most oft quoted proxies for the market. In fact it is quite a lop-sided proxy for it.
Here are some interesting facts sourced from Research Affiliates and Rob Arnott:
- From March 2000 to March 2002 the S&P 500 lost more than 20%, meanwhile the average U.S. listed stock gained more than 20% – this seemingly anomalous result is due to the market-cap weighted nature of the S&P 500 where more value is place on larger stocks
- If you look at only the top 10 stocks in the S&P 500 from 1926 to 2006 (a full 81 years of data), they outperformed the average US stock only 31% of the time over any 10 year rolling period
- What’s worse, is that if you try to find the number of years where 6 or more of the top 10 stocks by market cap in the S&P 500 beat the average stock: It never happened during the entire 81 years
So based on this, one could argue that if you bought a index tracking investment, one that tracked the S&P 490 (a fictitious index comprised of the S&P 500 less the top 10 stocks by market cap) instead of the S&P 500 might be better. The reason for this underperformance is attributed to the fact that the top 10 stocks tend to get that way because they are overvalued, and they also happen to represent about 25% or more of the S&P500 – again based on the market-capitalization nature of the index constitution.
wow That’s interesting … unfortunately I haven’t seen a Mutual Fund in Canada offered by the main banks, that follows Wilshire 5000 or Russell 3000. If you know one please share …
It would be interesting to know how often the members of the top 10 stocks change. If it is frequent, then trading costs and taxes would cause a drag on the returns of this fictitious index.
@MultifolDream$ – I have seen one or two index mutual funds that track the Wilshire 5000, but if you aren’t limited to mutual funds then there is no shortage of ETFs to track those same indices – also, the costs are roughly 1/5th of the index mutual funds. Note that those indices are also cap weighted, and as such the S&P500, Wilshire 5000 and Russell 3000 all behave fairly similarly. Here is a link comparing three ETFs that track these indices.
@Michael James: a very good point since the top 10 stocks can make up 25% of the total value of the S&P 500. Assuming that half of the 10 are dropped after breaking through into the top 10, and half are bought after falling into the 490 then the turnover would be close to 12.5% extra per year if there was an annual rebalancing. This is more than double of a regular index. Unless someone could back test that to see if the performance gain outweighs the trading and taxation costs then it’s probably best left a fictitious index! :)
Come to think of it, I just quickly looked up how to calculate portfolio turnover and it seems quirky as it’s calculated as the number of sales or buys (whichever is less) divided by the average monthly assets – again, this will give a lower turnover rate if the purchases/sales are larger cap stocks since a few stocks could dominate a portfolio so by dollar value the actual turnover could be higher than the calculation for portfolio turnover suggests… I’ll do some more digging into that – could be a good post. This would indicate that the extra turnover would be closer to three times as much as a regular S&P500 tracking investment… not good.
Hey Preet…another derivation of this is the Dogs of the Dow strategy where you buy the top 5 yielders on the DOW on Jan 1 and rebalance a year later, the theory being that the top yielders are undervalued relative to the market. Most studies show this to be a DOW beating strategy. There is even an ETF (DOD) that does this for you so no need to rebalance!
Thanks for the link Preet
@45free – thanks for the note. I should point out that DOD is actually an ETN not an ETF – so you won’t get the psychological high of dividends pouring into your account, and the IRS could actually decide to tax the gains as interest since it is actually a senior debt issue in structure and as far as I know, there is no consensus on the tax treatment. (p.s. I’m not normally such a sour-puss!)