For many decades, the key professional goal of many in the investment management industry has been to produce returns that exceed those of the S&P 500.
Recently, I've begun to question that mandate.
As the S&P 500 has become increasingly concentrated in sector and weight, it is worth questioning whether it still serves as an appropriate benchmark. In sticking with the broad-market index, we could inadvertently be exposing our clients and shareholders to additional risk.
Answering that question assumes understanding why we use the S&P 500 in the first place. This composite includes many more names than the 30-member Dow Jones Industrial Average. It became associated with a broader representation of the American corporate landscape in the last quarter of the 20th century.
While the Dow heavily favors industrial businesses — steel, chemicals, autos, oil and gas — the S&P 500 offers a more diverse representation. It includes banks, retail, consumer products and, notably, technology.
Also, the S&P 500 index is weighted by market value, which makes sense to professional investors. In contrast, for the price-weighted Dow, stocks with very high share prices have greater influence on the index's movement. A 10% move on a $100 stock has 10 times the impact that day compared to the same action for a $10 stock.
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A key benchmark for investors for decades
U.S. & World
By the mid-1980s, based on my own experience, most large-cap mutual funds had adopted the S&P 500 as their benchmark to beat. By the 1990s, the emergence of index funds provided viable alternatives for individuals and institutions, effectively replacing many individual stock portfolios.
Is there a problem now with either benchmarking the S&P 500 or owning that index? It depends on the objective.
If equity returns that equal or exceed the weighted composite of the largest profitable U.S. public companies is the goal, then the S&P 500 is still the bogey. The composition of the index has changed dramatically, but that has happened throughout its existence.
Table 1 shows how the sector weights of the S&P 500 have shifted over the past 30 years. For example, in the past, there were double the number of sectors accounting for at least 10% of the capitalization.
The technology and communications services sectors dominate the market, making the top of the S&P 500 appear more like the tech-centric Nasdaq Composite. However, these industries are led by massive enterprises that generate sales and earnings that were beyond belief 30 years ago.
Consider that in fiscal year 2023, Apple posted $383 billion in revenue and earned nearly $97 billion in net income. Meanwhile, Dow stalwart Procter & Gamble posted net sales of $82 billion in fiscal year 2023 and net earnings of $14.7 billion.
Bigger earnings and sales, plus heftier market caps
The market value of just Microsoft and Apple, the top leaders of the S&P 500, is approximately the same as that for the bottom 300 names in the entire index. This discrepancy, highlighted below, evolved through investor trading action that determines the full composite and is the embodiment of the S&P.
Just because an index changes weights or composition does not mean investors should assume it is less meaningful on certain measures. The S&P 500 might look more like the Nasdaq of old, with about 40% of its weight in tech and communication services, but business has moved in that direction.
However, that concentration raises the vulnerability to the technology and communications sectors and their largest constituents more than some investors may desire. Diversification no longer is the reality of past indices, particularly when the digital age has eliminated geographic and logistical constraints in most cases.
The table below shows that the number of stocks accounting for 30% of the broad-market index has shrunk. The current tally of eight is less than half the average for the past 30 years, with the dot-com tech surge encapsulating 30% of the S&P 500's value in 14 names, still far exceeding the status now.
The top 30% of the S&P 500 has increased the index's concentration in the tech industry and in a handful of those underlying names, raising the size-related risk, according to the table below. Other than in 2000, the recent configuration toward technology has never been close to the current structure.
Many commodity indices lower their oil weight because it dramatically biases the performance to the price of crude. For example, the Bloomberg Commodities Index applies a weight of about 30% to crude oil even though its production value weight is roughly 58% of the total, which is its allotment in the Goldman Sachs Commodities index.
Managing a heavier weighting toward tech
One way to reduce that tech-concentration risk is to buy the S&P 500 Equal-Weighted Index. While certainly not a proxy for the S&P 500, it provides more exposure to other industries and stocks.
As shown below, the equal-weighted S&P 500 has slightly outperformed the S&P 500 over the past 20 years.
As the two-year chart highlights, the trend reversed in recent years, driven by the big digital players.
We should consider the risk profile of the clients involved. To hedge our bets against overexposure to mega-cap tech and communications stocks, we should designate the allocation of each index or apply the appropriate benchmark.
Of course, if tech leads us higher forever, moving outside the weighted benchmark will be a negative. The S&P composite is no accident: Those weights are an aggregation of enormous amounts of data digested by all investors.
However, there will be years, as in 2022, when a sector that seems inconsequential to the S&P 500, such as energy, has tremendous performance. Participation in that industry will be more impactful with the equal-weighted portfolio and counteract the lack of weight in the regular benchmark.
The inherent concept of the weighted index, by definition the proxy of value across the U.S. public landscape, may not be entirely justified today because of the risks associated with high levels of concentration today both in names and sectors.
Karen Firestone is chairperson, CEO and co-founder of Aureus Asset Management, an investment firm dedicated to providing contemporary asset management to families, individuals and institutions.
