Measuring up – Are you sure your benchmark index is doing the job you think it is?


Kevin Murphy

Kevin Murphy

Fund Manager, Equity Value

Professional and private investors alike will often and without a second thought compare trading strategies or portfolio performance against a benchmark stockmarket index but are they right to do so? To examine that question further, let’s consider the development of the S&P 500 – the broad us market index that comprises 500 large companies and is one of the world’s better-known benchmarks.

Before the advent of computers, it was hugely difficult to calculate what a market index was or how it should be priced and indeed, for almost four decades from 1884, the Dow Jones 30 – forerunner of the Dow Jones industrial average – was the only one that did. This was, however, an index made up solely of industrial companies so standard & poor’s (S&P) set out to create something more broadly based.

First published in 1923, the resulting index covered 233 companies across 26 sectors but, because it was so hard to calculate, it was only updated once a week. To give investors a more timely indication of the state of market, therefore, from 1926 S&P provided a pared-down index of 50 industrials, 20 utilities and 20 rail stocks, which could be updated at the revolutionary rate of once an hour.

By 1957, this ‘composite’ index had expanded from 90 to 500 companies but it was only in 1976 that any change was made to its sectoral make-up. From 425 industrials, 60 utilities and 15 rail stocks, the S&P 500 was restructured to consist of 400 industrials, 40 utilities, 20 transportation companies – adding airlines, air freight and trucking to rail stocks – and 40 financials.

Given the sway the sector holds today, this may sound surprising and yet, up to this point, financials had only been traded ‘over the counter’, making the calculation of price movements very complicated indeed. Nevertheless, anyone considering the longer-term performance of the S&P 500 today would do well to remember that, for the first 50 years of its existence, it was an ex-financials index.

A still more significant development came in 1988 when – in response to the surge in merger and acquisition activity over the preceding decade or so – it was decided that, rather than having set limits, the number of companies in each of the four industry groupings would be allowed to float, so as to more accurately reflect the make-up of the us economy.

Here on The Value Perspective, however, what we find most eye-catching of all about the S&P 500 is not a particular change but something that has remained constant throughout its history. this is the way it is constructed from the bottom up, with S&P picking out sectors that are important to the us economy and then allocating to the index a representative sample of companies within each sector.

In other words, the S&P 500 does not comprise the 500 largest or most expensive companies in the US market, which would be the case if it was respectively capitalisation or price-weighted. Instead, it is simply 500 companies – spread across four major sectors – that have been arbitrarily identified by a committee as suitably representative of the US economy.

Furthermore, when it was first set up, the S&P 500 could be said to be representative of 90% of the total quoted value of the US market but today that percentage has fallen to 68%. All of which suggests investors should handle market indices with care and certainly not take them at face value. What is any benchmark actually measuring and is it really doing the job you think – or are being told – it is?



Kevin Murphy

Kevin Murphy

Fund Manager, Equity Value

I joined Schroders in 2000 as an equity analyst with a focus on construction and building materials.  In 2006, Nick Kirrage and I took over management of a fund that seeks to identify and exploit deeply out of favour investment opportunities. In 2010, Nick and I also took over management of the team's flagship UK value fund seeking to offer income and capital growth.

Important Information:

The views and opinions displayed are those of Nick Kirrage, Andrew Lyddon, Kevin Murphy, Andrew Williams, Andrew Evans, Simon Adler, Juan Torres Rodriguez, Liam Nunn, Vera German and Roberta Barr, members of the Schroder Global Value Equity Team (the Value Perspective Team), and other independent commentators where stated.

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