(MarketWatch) Beating the stock market may be easier than you think. All you have to do is pick the right benchmark. The good news is there are a lot of choices.
For instance, imagine that you are a large-cap value manager. Do you compete against the Russell 1000 Value index or the S&P 500 Value index? Both are well-known, widely-followed, and respected benchmarks for the large-cap value sector. And, yet, only one of them invests in Apple.
That makes a big difference, since both indices are cap-weighted and Apple has one of the largest market caps of any stock. Its presence or absence therefore plays an outsized role in the performance of a cap-weighted index. The stock currently represents 8.7% of the SPDR S&P 500 Value ETF, but has no allocation in the Russell 1000 Value Index.
This year is a good illustration of how big a different this can make, since Apple is up more than 50% so far in 2019. Almost exclusively because of Apple, the SPDR S&P 500 Value ETF as of Oct. 30 is 3.6 percentage points ahead of rival iShares Russell 1000 Value ETF for year-to-date return — 23.4% versus 19.8%.
A 3.6 percentage point difference in a 10-month return may not seem a big deal, but in the world of performance monitoring it is huge. In many if not most cases, a fund will beat or lag its benchmark by less than a percentage point. So the choice of large-cap value benchmark has huge consequences for how many large-cap value managers “beat the market.”
To illustrate how a cunning manager could take advantage of this situation, imagine that you are a large-cap value manager and, at the beginning of 2019, you believed Apple would be a standout performer for the year. You would want to designate the Russell 1000 Value index as the benchmark for determining whether you have beaten the market, since it does not contain Apple. If Apple does as well as you believe it will, your portfolio that owns the stock should handily beat your benchmark.
In contrast, imagine another year in which you are convinced that Apple will lag the market. In that case, you would want to designate the S&P 500 Value index as your performance benchmark, since it does contain Apple. If Apple lags the market, your portfolio that doesn’t own it should handily beat your benchmark.
To be sure, it’s not every year that the stock with the best returns also has the largest market cap and therefore dominates any cap-weighted index. But it’s not all that rare, either.
Perhaps the most spectacular historical example of this phenomenon came several decades ago in the international equity arena. The Japanese stock market skyrocketed in the 1980s, and by the late 1980s its equities had more than a 60% weighting in what, at that time, was the most popular international equity benchmark — MSCI’s Europe, Australasia and Far East Index [EAFE], a cap-weighted index.
Most international equity managers recognized that Japanese equities had formed a bubble, and either underweighted Japanese stocks in their portfolios or avoided them altogether. When that bubble deflated in the decade of the 1990s, it therefore looked as though an outsized proportion of such managers were “beating the market.”
A more recent example was something I hinted at a month ago, when I reported that more than half of midcap stock managers beat their benchmark in 2018, an unusually high number. But this result was calculated using the S&P 400 Midcap Index as the benchmark. The Russell Midcap index’s return in 2018, in contrast, was three percentage points better, and relative to it, a significantly smaller percentage of midcap managers came out ahead.
So welcome to the wild and crazy world of stock-market benchmarks. If you’re like most investors, you assume that the various benchmarks are constructed using essentially similar criteria, and are therefore largely interchangeable. In fact, they are anything but.
