RETURN ON INVESTMENT: Does the S&P 500 Index Make Sense?

• Author: Freed, Glenn

Although fought against for many years by the investment advisory industry, the use of low-cost index funds, particularly the S&P 500 Index, have become widely accepted and utilized by investment advisers.

Led by Vanguard, State Street and Blackrock, 50 percent of the top 10 mutual funds/exchange-traded funds in the United States track the S&P 500. Buttressed by a compelling combination of very low costs and relative outperformance that embarrasses most active managers, the S&P 500 is considered a one-stop-shop by many investors and a key component of most institutional portfolios.

Most of the investment advisory industry has traditionally promoted "active management" strategies involving the careful selection of individual stocks to cut stock risk or increase stock return. Active management is difficult primarily because the public equity markets are very efficient. Virtually all information and expectations about any given company and the economy become instantly baked into stock prices. Therefore, "beating the market" requires that an active manager predict an event that is not already expected or occurring.

It's a tough road for the manager and a tough road for those trying to pick those managers who will beat the market.

There has been much research discussing the fact that most portfolio returns are due to asset allocation the decisions about categories of investments to hold (e.g., U.S. stocks, international stocks, bonds, cash, etc.). So the idea behind indexing the market is that if the majority of the return of the stock or bond markets is just being in the market to begin with, why pay for active management which overall probably doesn't make much difference anyway? Hence the appeal of index funds. Keep the expenses low and don't take the chance that an active manager will mess it up by not getting the "market" return.

Which brings us to the question: What is the market return? Is it the Dow, the S&P 500, the Russell 1000 or something else?

The Dow is a rather odd bird with its value computed by combining the share prices of its 30 constituents. So, if one company has a $50 share price while another has a $25 share price, the former has twice the weight of the latter. That doesn't make much sense. Neither does the idea that just 30 stocks represent the return of the overall U.S. stock market.

With approximately 500 individual holdings, the S&P 500 is a better representation of the U.S. stock market than the Dow. That said, many...