By Bruno Giordan
It seems that every time I turn around, or read or hear someone talk about investing, I’m told that investing in a mutual fund mirroring the S&P 500 Index over the past few years would have out-performed some huge percentage of active money managers, like 90 percent or 95 percent. Like most statements, that one intrinsically just doesn’t seem to make any sense. I think it needs more critical attention and more analysis.
Could it be that the 90 percent or 95 percent of mutual fund mangers are so inept or that their expenses are so high that either or both drag the performance down or that they have lousy research? What if I put forth the suggestion that none of the above is true, and that the reason that the S&P 500 Index mutual fund apparently outperforms the active mutual fund manager is because we’re comparing apples to oranges? Let me explain.
The S&P 500 Index that we see so widely quoted as a reflection of the overall market is capitalization-weighted, it’s not an equally weighted index. Therefore, it’s not truly representative. For instance, there are currently 500 stocks represented in the S&P 500 Index, but it’s not one share of each stock or ten shares of each stock or what have you. Instead, it’s the number of shares outstanding, however many shares that is, times the current market price per share.
For example, if you take a company like General Electric which has billions of shares outstanding, that company’s performance will have a much greater impact on the performance of the S&P 500 Index than the smaller companies. As a comparison, take a small company like Great Lakes Chemical that, like General Electric is a leader in its industry. It has 59 million shares outstanding with a price of about $50 a share, compared to General Electric that has over 3 billion shares outstanding with a price of $70 a share. To put that in context, the market capitalization of General Electric is roughly $230 billion. The market capitalization of Great Lakes Chemical is about $3 billion. In other words, the impact of General Electric is about 77 times larger than the impact of Great Lakes on influencing the performance of the S&P 500 index, when you take into account “capitalization-weighted.”
Keeping that in mind, if you were the manager of a mutual fund doing active management, I guess that you, just like most active managers, would build your portfolio based on what you think about the future performance of the company, not on the market capitalization. For instance, if you had $100 million in your mutual fund, you might want to pick 50 or 60 great companies to put in the portfolio. But I suggest that since you don’t know which company or product concept is better than the other, that you’d most likely relatively equally weight your investment among each of the 50 ideas. Even if you didn’t, you certainly wouldn’t have 77 times more in any one company than the other.
If, as a portfolio manager you decided that you liked both General Electric and Great Lakes Chemical and you invested about $2 million in each company, that would be “equally-weighted” as differentiated from “capitalization-weighted.” Using that same thought process, if you as a portfolio manager wanted to make your investment based on capitalization then you’d have close to $4 million invested in General Electric and only $50,000 invested in Great Lakes Chemical. I don’t know about you, but I wouldn’t want my life savings managed that way.
What if, instead of using an S&P 500 Index that was “capitalization-weighted”, we used an S&P that was “equally-weighted”? What if we used the same 500 companies that make up the S&P 500 Index, but instead of having them weighted by capitalization, we’d give each company the same weight in the Index? If Great Lakes goes up by 10 percent, the impact on the portfolio would be the same as if General Electric went up 10 percent. In other words, they’d both have equal impact. In the equally-weighted portfolio, General Electric would not have about 77 times more importance than Great Lakes. The difference in how this impacts on performance is significant.
If you were to compare the past three years (1995, 1996 and 1997), the performance of the S&P 500 (capitalization-weighted) and the S&P 500 (equally-weighted) with the Investors Business Daily Mutual Fund Index (IBDMFI), you would get an entirely different result than is currently being touted. By the way, the IBDMFI is an index of 23 actively-managed equity funds: not the best, not the worst.
Consider the difference in performance. For instance, if the cumulative percentage performance over the three years of the S&P 500 “capitalization-weighted” was almost 124 percent, the S&P 500 “equally-weighted” was about 66 percent. The Investors Business Daily 23 actively-managed Equity Funds Index is about 72.4 percent. Clearly, an equally-weighted S&P 500 Index did not outperform the typical mutual fund.
As a matter of fact, if you were to concentrate on what were some of the better performing mutual funds over the past three years, their performances would have been markedly superior to the S&P 500 “equally-weighted” index.
Stop and think about it for a minute. If you were considering investing in mutual funds, would you invest 77 times more money in Fidelity Magellan than you would in Alger Small Cap just because the Magellan is more than 77 times larger than Alger? Of course not; it’s a ridiculous thing even to contemplate, and yet that’s exactly what these pundits, who are perpetrating this hoax (probably unknowingly), are suggesting that you do when they say to invest in an S&P 500 Index that’s capitalization-weighted.
In summary, I just can’t imagine why anybody would mistakenly compare the performance of an actively-managed mutual fund against an index that in no way reflects the way one would invest. If we’re going to compare actively-managed mutual fund performance to the S&P 500, let’s compare it to an S&P 500 that’s more equally-weighted. That would make more sense. I suggest that if you do, you’ll find that the actively managed mutual funds, especially the good ones, outperform the equally-weighted S&P.
You might argue that, regardless of how the S&P 500 capitalization-weighted index is constructed, if it in fact outperforms the average mutual fund, then why not invest there? Great idea, when those large companies are performing well. When those very highly “market-capitalized” companies’ stocks have a problem, which they will—it’s just a question of time, that reality will have more impact on the S&P 500 Index capitalization-weighted index than you would want to have in a prudently managed fund.
In case you forgot, here’s what happened to some very large companies that many pundits thought of as “recession proof” in the1973-1974 Bear Market: Coca Cola (-70 percent price change), General Electric (-60 percent), General Motors (-66 percent), Phillip Morris (-50 percent), Walt Disney (-85 percent), Westinghouse (-85 percent).
Remember that when you invest blindly in the S&P 500 Index, you will receive great returns when the large companies are doing well, and you will get soundly trounced “when” we get something like the 1973-1974 bear market performance. Not “if” but “when.”
Bruno Giordano is president of Dorset Financial Services in Devon, Pennsylvania.