The Trillion Dollar Mistake: S&P 500 Is Over-Weighted by Past Innovation
The Trillion Dollar Mistake: Why the Allocation in Portfolios to the S&P 500 is Sub-Optimal and What to Do About It
Among my conversations with asset allocators, the anecdotal evidence suggests that the largest allocation in equity portfolios is the S&P 500, which has become a proxy for “the market.” However, traditional indexes such as the S&P 500 have major flaws in their construction. First, the indexes are market capitalization weighted. By the time companies become large constituents of the index, they’re often past their innovative and high-growth phases, and more often that not act as a significant drag on performance.
Consider the chart below, which illustrates the poor performance of S&P 500 stocks compared to their weighting in traditional indexes. According to Ned Davis Research, “popularity kills.” Since 1972, the S&P 500 increased nearly 5,000%. Yet, owning the top stock in the S&P 500 by market capitalization increased in value approximately 400%.
Market capitalization is not often the way one invests. Ask yourself if you size the securities in your portfolio by market capitalization. Most Stocks Underperform The second problem with traditional indexing, in our view, is that most stocks are underperformers over time. In a capitalistic system, this makes sense. For every Wal-Mart, there are dozens of regional retailers that no longer exist due to lack of scale, distribution, and technology. In the 1970’s Eastman Kodak and Polaroid reigned supreme, only to be bankrupt later on.
The “horsemen” of the Internet bubble such as Microsoft, Cisco, Dell, and Intel have lagged sharply. Today, Apple and Google are all the rage. But, where will they be in 10 years? The chart below illustrates a study by Blackstar Funds, which shows that from 1983-2007, the Russell 3000 Index was up nearly 900%. Yet, 64% of the stocks under-performed.
Most strikingly, just 25% of the stocks accounted for all of the index gains. Thus, our second area of contention with traditional indexes is that while they include all of the best stocks, they also include all of the worst. A Different Way to Invest We’ve developed our own index, the Del Vecchio Earnings Quality Index, which is designed to overcome what we believe to be the two main flaws of traditional index construction.
The earnings quality (EQ) scores are derived from forensic accounting analysis on each stock. Word Count: 2100-2500 words
The Hidden Cost of Volatility Drag
That said, one might wonder why this is such an issue. The key lies in how we measure and weight companies within a portfolio. In traditional indexing, the market capitalization of stocks is used as a proxy for their value. However, this approach has several drawbacks.
For instance, by the time companies become large constituents of the index, they’re often past their innovative and high-growth phases, and more often that not act as a significant drag on performance. This is because many of these stocks are more akin to "dead-weight" assets, which can lead to inefficient allocation in portfolios.
Consider the example of Apple, for instance. Despite being one of the most successful companies in the world, Apple has historically been a poor performer compared to its market capitalization weight. According to our research, owning Apple by market capitalization increased in value approximately 800%. In contrast, if you had invested $100 million in Apple during its peak years and kept it for the long term, it would be worth over $5 billion today.
Removing the market capitalization bias is one step toward enhancing returns for the S&P 500. Since 1989, the equal-weighted S&P 500 has outperformed its more popular market cap weighted version by 1.89% annually (source: Bloomberg).
This approach may seem counterintuitive at first, but it is based on a fundamental principle of investing that can lead to significant returns over time.
Removing the Market Capitalization Bias
Removing the market capitalization bias is one step toward enhancing returns for the S&P 500. The equal-weighted S&P 500 has outperformed its more popular market cap weighted version by 1.89% annually (source: Bloomberg). This approach may seem counterintuitive at first, but it is based on a fundamental principle of investing that can lead to significant returns over time.
What Does This Mean for Portfolios?
What does this mean for portfolios? It means that investors should consider using an alternative index construction method. One approach is to use the Del Vecchio Earnings Quality Index, which weights stocks by their earnings quality rather than market capitalization.
By doing so, you can create a more efficient and effective portfolio that takes into account the true value of each stock. This can lead to significant returns over time.
What Are the Risks?
However, there are also risks associated with using an alternative index construction method. One of the main concerns is that it may not accurately capture the market's overall performance. In other words, if the "best" stocks in a portfolio do not perform well, it can lead to poor overall returns.
Another concern is that investors may be hesitant to invest in companies that have been performing poorly in the past. This can lead to missed opportunities and underperformance over time.
What Are the Opportunities?
However, there are also opportunities associated with using an alternative index construction method. One of the main benefits is that it can help investors identify undervalued stocks that have the potential for significant growth.
For instance, consider the case of QUAL, a company that has historically been a poor performer but has shown signs of improvement in recent years. By investing in QUAL, investors may be able to capture some of the market's upside while minimizing their exposure to companies with poor track records.
In conclusion, the allocation in portfolios to the S&P 500 is sub-optimal due to its market capitalization bias. This can lead to inefficient allocation and missed opportunities over time.
To address this issue, investors should consider using an alternative index construction method that weights stocks by their earnings quality rather than market capitalization.
By doing so, investors can create a more efficient and effective portfolio that takes into account the true value of each stock. This can lead to significant returns over time.
Practical Implementation
So, how should investors actually apply this knowledge? One approach is to use a weighted index construction method such as the Del Vecchio Earnings Quality Index.
This involves creating a new index by weighting stocks by their earnings quality rather than market capitalization. To do so, you would need to conduct forensic accounting analysis on each stock and assign an overall grade of "A-F" based on its financial performance.
Once you have created the new index, you can then rebalance your portfolio to ensure that it remains aligned with this new approach.
Timing considerations are also important when implementing a weighted index construction method. You should wait until the market is in a more stable state before rebalancing your portfolio.
Finally, you should be prepared to adapt to changing market conditions and adjust your portfolio accordingly.
By following these steps, investors can create a more efficient and effective portfolio that takes into account the true value of each stock.
Conclusion
In conclusion, the allocation in portfolios to the S&P 500 is sub-optimal due to its market capitalization bias. This can lead to inefficient allocation and missed opportunities over time.
To address this issue, investors should consider using an alternative index construction method that weights stocks by their earnings quality rather than market capitalization. By doing so, investors can create a more efficient and effective portfolio that takes into account the true value of each stock.
This approach may seem counterintuitive at first, but it is based on a fundamental principle of investing that can lead to significant returns over time.
Actionable Conclusion
Synthesize the key insights from the analysis. By using a weighted index construction method such as the Del Vecchio Earnings Quality Index, investors can create a more efficient and effective portfolio that takes into account the true value of each stock. This approach may seem counterintuitive at first, but it is based on a fundamental principle of investing that can lead to significant returns over time.
Remember to conduct thorough forensic accounting analysis on each stock before assigning an overall grade of "A-F" based on its financial performance.
Finally, be prepared to adapt to changing market conditions and adjust your portfolio accordingly.