Why The S&P 500 Is A Useless Benchmark For Actively Traded Funds

One of the most important elements of running or investing in a hedge fund or other actively traded fund is to establish a benchmark. Benchmarks enable fund managers to show how they are doing against the broader market in which they trade. Using their benchmark, fund managers can demonstrate to potential investors that they’re outperforming the broader market.

The S&P 500: index or arbitrary list?

As a result, many fund managers use the S&P 500 as one of their benchmarks because it is widely seen as the go-to representative of the U.S. stock market. However, one fund manager argues that the S&P is a totally useless benchmark for both funds and individual investors alike.

Guy Davis of ETF manager GCI Investors uses the S&P 500 as the benchmark for his actively managed exchange-traded fund because he believes investors will compare his ETF to it whether he uses it or not. He runs a concentrated, long-only U.S. equity strategy called the Genuine Investors ETF, which trades under the ticker symbol GCIG and holds 20 to 30 stocks. 

Davis’ top 10 holdings are currently GFL Environmental, Microsoft

MSFT
, Booking Holdings, Crown Castle International

CCI
, Mastercard

MA
, First American Financial

FAF
, Meta Platforms, Air Products and Chemicals

APD
, Amazon, and American Tower

AMT
. However, when he is making changes to his fund’s portfolio, he doesn’t pay any attention to the S&P 500 even though it is listed as his benchmark.

Why the S&P 500 is no longer good for tracking market performance

Davis offers several reasons why he thinks the S&P 500 is a useless benchmark. For one thing, he points out that the S&P 500 of today isn’t the same as it was in years past. As a result, he says comparing the index’s current performance with its past performance doesn’t make any sense.

“People often compare the S&P 500 over time,” Davis said in an interview. “They show charts showing the S&P is trading at all-time high multiples compared to historically… I think all those comparisons are meaningless. There are completely different weightings. They’re not comparing apples to apples.”

Since the S&P is widely used to represent the U.S. stock market as a whole, many analysts offer predictions about where they think the index will be at the end of the year, but Davis thinks it’s ridiculous.

“All these guys on CNBC are quoting their S&P 500 year-end targets,” he said. “How does anybody have any idea about the millions of variables that determine the level on each day? Even if you could predict these variables every day and see how everybody is going to interpret them in an index target… I think it’s ridiculous, like trying to predict the weather in 10 years’ time.”

Sector weightings and diversification

Davis pointed out that today’s sector weights in the S&P 500 are entirely different from what they were 10 years ago when energy had about a 13% weight, and tech had less than a 20% weight. However, today, tech has a more than 40% weighting in the index — despite the claims of diversification made by the S&P Dow Jones Indices.

“S&P will tell you that technology isn’t over 40%,” Davis explained. “The only reason is that two years ago, they created a new sector out of nowhere called communication services. They put half of technology services in there, but the index is still 40% tech. I think it’s risky. They arbitrarily created a new sector. The companies are the same; they just moved them around.”

Most portfolio allocators will emphasize the importance of diversification, but with the S&P being 40% tech, it isn’t as diversified as it used to be. Davis warns that investors are taking on more risk when investing in the S&P 500 today than they were just five years ago. 

He explained that the average investor might think that buying more stocks equals more diversification and thus less risk. However, he believes it is less risky to buy five stocks you know everything about than to pick 500 stocks you don’t know anything about arbitrarily. Thus, the argument that buying the S&P 500 is an excellent way to diversify your portfolio is incorrect.

“Mathematically, once you are past 15-20 stocks, the mathematical benefit from diversification drops to almost zero,” Davis said. “You don’t need to go to 500 stocks… I think lots of investors in the industry use diversification as an excuse for not doing the hard work and selecting a small number of companies. Also as an industry, most portfolio managers are selling a product, and one of the things with diversification is that you end up bringing your returns [down] to average.”

A product driven by popularity

Davis said one of the core issues with the S&P 500 is that it is a product that S&P Dow Jones Indices is trying to sell. He argues that everything S&P does with the index is just “window dressing” because it doesn’t want people to move away from using it as a benchmark. Davis believes S&P wants to make it look like a diversified index, but with tech making up 40% of the weighting, the diversification argument seems incorrect.

He also pointed out that the S&P 500 is popularity-driven rather than driven by the size of the companies it contains. The index once represented the 500 largest U.S. companies, but today, that’s not even remotely the case.

“Back when the S&P was created, it was the 500 largest companies in the U.S.,” Davis said. “Today, there’s no relation to business size. The S&P 500 is a popularity index rather than a size index. These are the 500 most popular stocks. It has nothing to do with company size.”

Jason Meklinsky of global financial services provider Apex Group agrees.

“Both individual investors and hedge funds are so wedded to the S&P as an index to benchmark against it because it’s familiar,” Meklinsky said in an interview. “They understand it, they can disaggregate it, slice and dice it, and make a comparison to how an investment manager did from a retail perspective. But it’s not the biggest companies. It’s a popularity contest, and it doesn’t, in my opinion, reflect the largest 500 influential companies in the world. How they end up in the index is more… quantitative, not qualitative, but everyone loves to benchmark to the S&P.”

Market cap weightings

The S&P 500 is weighted by market capitalization, which means movements in the stocks with the largest market caps have an outsized impact on their performance. In 2021, only five stocks (Tesla

TSLA
, Alphabet, Microsoft, Apple

AAPL
and NVIDIA

NVDA
) accounted for about a third of the gains in the S&P and 45% of the gains since the beginning of May. 

Additionally, the 10 largest stocks in the index make up almost 30% of its market value. Davis pointed out that while Tesla is nowhere near being one of the top 10 companies in the U.S., it is in the top 10 stocks on the S&P due entirely to its popularity, which has inflated its market cap. 

On the other hand, Walmart

WMT
tops the list of the largest U.S. companies by revenue, but it’s nowhere in the top 10 in the S&P 500 due to its smaller market cap.

Arbitrary selections

Davis emphasized that business value is not the same thing as stock price or market cap and pointed out that the selection of the companies in the S&P is entirely arbitrary. 

“An internal committee decides which stocks, and the exact reasoning and rationale are never available to everyone else,” he said. “You may recall when Tesla was due to go in, but it didn’t go in for a while. It’s bizarre. There’s a secret team sitting behind the scenes and running secret criteria [in choosing companies].”

Given the nature of the selection process, Davis argues that anyone could create their own S&P 500 in Excel. However, people pay for the S&P name. 

“Fifteen years ago, it had no fundamental value because anyone could create it,” Davis said. “Indices are now worth billions of dollars because they are products to sell. There’s been a significant industry shift.”