Insights on Indexes

The Suspects

S&P 500

The S&P 500 is market capitalization weighted. This means larger companies have more influence in the index calculation.

The 10 largest companies account for more than 21% of the index: AAPL, MSFT, AMZN, FB, BRK.B, JPM, XOM, GOOGL, GOOG, JNJ. That is a strong weighting to technology driven firms. Such a focus can drive up the Risk without materially impacting the Expected Value of a given portfolio simply due to a lower level of diversification in the index.

This maybe a case of Berkson's Paradox, a cognitive bias where the statistical sample is not representative.

Consider: Put 500 stocks in an index with one share each from a diverse set of 499 companies and 130 shares from a single company. That puts about 21% of the portfolio in one company.

By having 500 stocks, we may be diversified across industries and businesses but the overriding results will likely be driven by 130 shares in a single stock.

Dow Jones Industrial Average

The Dow Jones Industrial Average is price weighted meaning higher priced stocks have a greater weight and influence in the index calculation.

It has 30 stocks in it and excludes Utilities and Transports as those were separately indexed when the DJIA was created.

And, in a nod to random rules, the selection committee keeps the ratio of the highest stock price to the lowest at less than 10 to 1. This excludes companies like Alphabet, Amazon and Berkshire Hathaway from being considered.

Currently, the 5 most expensive stocks account for nearly 20% of the index: BA, UNH, MMM, GS, HD.

Similar to the S&P 500, a few stocks can cause an imbalance in influence that increases risk relative to a truly diversified portfolio.

NASDAQ

Like the S&P 500, the NASDAQ Composite is market capitalization weighted. It contains over 3,300 of the equities listed on NASDAQ.

This index suffers in the same way as the S&P 500 regarding unbalanced impacts of larger companies. The NASDAQ Composite is over 46% Technology and 20% Consumer Discretionary - nearly two-thirds in two Sectors.

Why it is important

Company capitalization is an important measure when considering business stability and perhaps longevity. These, among other attributes we might choose, contribute to making an informed decision on investing.

There is no evidence that large capitalization stocks deliver better gains than others. Historically, higher capitalization stocks were stable with slow price appreciation coupled with good dividends. So, while generally delivering lower risk, this approach will not likely deliver the level of Alpha we desire.

As to using price for weighting as the DJIA does, that is likely the least useful measure. Coupled with too small of a sample, rules that eliminate entire Sectors and singularly high priced stocks, this index is not at all relevant in today's markets.

Another dimension to consider is the impact of ETF, Mutual Fund and institutional investors as they benchmark billions against these indexes. Like Brownian motion, the ebb and flow of money among the index's stocks will create imbalances that may be short or long term in nature yet have nothing to do with the companies and their potential to make an investor profitable.

Our goal is to increase our Expected Return at our chosen level of Risk. That may or may not lead to beating an index during some time periods.

Our interests might be better served to compare each equity to its Sector and look for the higher performing stocks in each. With a rational diversification plan across the sectors coupled with the higher performers from those sectors, our performance may be materially better (meaning improved Expected Value at a given level of Risk) than a focus on individual equity performance against an index might be.

We may also find that a Sector level index based on equal weight, price to earnings ratio, growth, P/E to Growth (PEG), ROI, Cash Flow ROI, Discounted Cash Flow, Return on Assets, or intangible elements such as leadership team tenure yields a better rationale for choosing individual equities.

And, it is entirely possible that none of these independently provides an effective answer. Clearly, price weighted, capitalization weighted or equal weighted taken alone are entirely too simplistic to deliver improved performance though they can provide some initial guidance and a benchmark to compare relative performance.

Finally, keep in mind that to buy low and sell high, entering sectors and equities that are out of favor is not a bad thing. Some of the largest annual gains will come from positions entered when the equity was in disfavor yet had a good forward story. Patience is paramount as is selecting options with sufficient time to expiration for the thesis to play out.

Learnings and Actions

We will rely on the S&P 500 as the best of the worst for our benchmarking. Benchmarking is a critical element in performance management. Choosing an industry standard as the benchmark is much more defensible than creating one from whole cloth.

It is logically impossible to generate Alpha by matching the benchmark. We will not rely on the distribution of assets inside the index for anything other than a start point for a conversation on the best diversification plan for the month, quarter or year.

We think the greatest potential for generating Alpha is in making informed choices on Sector weighting and the individual stocks in those Sectors.

"Benchmarking, generally, is far from a science."-- Brian Hamilton