What do market benchmarks measure?

Part 1: Exploring the truth about benchmark investing

What do market benchmarks measure?

Let’s say you just moved into an area where local sports fans follow several baseball teams — like the Cubs and White Sox in Chicago, or the Mets and Yankees in New York. Obviously, you want to cheer for a winner, so you pick your new club based on how well they did in 2016. When they suddenly begin to flounder, you discover that the team had a handful of superstars who all got hurt or were traded, and the team is now mediocre in their absence.

Now apply that to investing. In 2015, the S&P 500 Index had a total return of 1.4%. But if you took away just four stocks — Facebook, Amazon, Netflix and Google — the index would have suffered a loss of almost 3%.1 In that year, an investment in the S&P 500 Index was driven largely by the success of these stocks.

The point here isn’t that any choice is “right” or “wrong.” But when you make a choice, whether as a sports fan or especially as an investor, you need to fully understand just what you are choosing. How does a stock “make the team” to be included in an index?

In this blog series, we will examine some common myths about benchmark investing versus active investing, and discuss what you need to know about both in order to make choices about what’s right for you. To set the stage, we review benchmark indexes. What exactly are these, and how do they draft their “players?”

What is a benchmark index?

A benchmark index is a group of stocks that is intended to represent the value of a given market. For example, the Russell 1000 Index, the S&P 500 Index and the Dow Jones Industrial Average (DJIA) are all widely quoted benchmarks for US stocks — even though the Russell index contains about 1,000 stocks and the DJIA contains just 30.

Nearly all benchmark indexes are weighted by market capitalization — which is calculated by multiplying a company’s share price by the number of its outstanding shares. (In the case of the DJIA, it’s simply weighted by share price.) This means that the companies with the largest market cap have the largest weight and therefore have the most influence over the index’s overall performance. Companies with smaller market caps have less influence because they represent a smaller portion of the index.

Do companies deserve higher weightings based solely on market cap?

Since market-cap weighting is largely determined by a stock’s price, it makes sense to use benchmark indexes as a compass for recent market sentiment. And, the historical performance data from various indexes is also extremely valuable in research. But what about as an indicator of future performance? After all, that’s what investors are most concerned about.

We don’t believe that by itself, total market cap defines the future potential of any investment. Keep in mind that there are many reasons why stocks go up (pushing market cap up as well), and some have nothing to do with the fundamentals of the company. For example, consider what happened to Facebook in December 2013. That month the company joined the S&P 500, and on the day of the announcement the stock surged 4%. So passive index investors were obligated to pay a higher price for Facebook even though nothing changed regarding its business model.

Another example is the dot-com bubble of 1999 and 2000, when technology companies were all the rage and became notoriously overvalued. But the larger each became, the more weight each carried within benchmark indexes, and this had nothing to do with business success or even a product in many cases — just investor excitement. Since that time, we have also experienced bubbles in real estate and commodities as investors flocked to these sectors and pushed up prices.

How will you choose your portfolio players?

Investing in benchmark indexes can result in something you want to avoid — buying stocks when prices and emotions are high. Because the most expensive issues can dominate market-capitalization-weighted indexes, you may wind up buying more shares of overvalued companies while leaving potentially much better deals on the table.

On the other hand, active fund managers look at company fundamentals in order to make investing decisions, and smart beta funds track indexes that are weighted by factors other than market cap. Different managers will be more skilled than others, of course. But they’re all seeking tomorrow’s opportunities — not yesterday’s.

We believe investing success is far more likely when you truly understand what you own and why you own it. Active, smart beta and traditional passive strategies can all play a role in a well-constructed portfolio, but you have to know why you’re choosing these players to join your team. Talk to your advisor about any questions you may have about your portfolio allocation.

1 Source: FactSet Research Systems, Inc. Note that Google is now known as Alphabet.

Important information

Blog header image: Eva Gruendemann/Shutterstock.com

The Russell 1000® Index is an unmanaged index considered representative of large-cap stocks. The Russell 1000 Index is a trademark/service mark of the Frank Russell Co. Russell® is a trademark of the Frank Russell Co.

The S&P 500® Index is an unmanaged index considered representative of the US stock market.

The Dow Jones Industrial Average is a price-weighted index of the 30 largest, most widely held stocks traded on the New York Stock Exchange.

An investment cannot be made directly in an index.

Tracy Fielder
Product Management Director
Strategist — Rethinking Risk

Tracy Fielder is a Product Management Director for Invesco covering US Value strategies. He works with Invesco’s US Value investment teams and client portfolio managers to develop sales and marketing programs, positioning Invesco’s product line across all global distribution channels.

In addition to his product management responsibilities, Mr. Fielder is part of a team that develops the themes, researches the data and presents the concepts of Invesco’s Rethinking Risk program. This educational program seeks to encourage a holistic view of risk, considering market history, investor psychology/behavior, and asset allocation theory/application. This program also looks at the impact of risk parity, a portfolio construction approach that diversifies across sources of risk in relation to various market and economic environments.

Prior to joining Invesco in 2010, Mr. Fielder was vice president of Investment Research at VALIC (Variable Annuity Life Insurance Co.), responsible for leading a team of analysts overseeing the selection and monitoring of all mutual fund managers and sub-advisors utilized for defined contribution retirement plan clients. Before joining VALIC, he was an account executive at Van Kampen Investments where he was in charge of marketing and sales for the Van Kampen mutual fund product line distributed by Morgan Stanley Dean Witter financial advisors. He entered the financial industry in 1993 as a marketing coordinator for PaineWebber.

Mr. Fielder earned an MBA from Houston Baptist University and a BBA, cum laude, with a concentration in finance from the University of Houston. He holds the Series 6, 7 and 63 registrations.


Marie Jordon
Senior Product Manager

Marie Jordon is a Senior Product Manager for Invesco. She works with a number of Invesco’s fundamental equity investment teams to develop sales and marketing programs, positioning Invesco’s product line across all global distribution channels.

In addition to her product management responsibilities, Ms. Jordon works on a team dedicated to Invesco’s Rethinking Risk thought-leadership program. The Rethinking Risk program articulates Invesco’s holistic approach to risk, by considering market history, investor psychology and behavior, and asset allocation theory and application. The program also discusses the merits of diversifying portfolios across sources of risk in relation to various market and economic environments.

Ms. Jordon assumed her current role in 2009. From 2002 – 2009 she worked as an investment services analyst working with Invesco’s subadvised, offshore and institutional clients. She entered the financial industry in 1999 when she joined Invesco, working in the retail distribution channel

Ms. Jordon earned a B.B.A. in Marketing from Texas A&M University in College Station. She holds the Series 7 and 66 registrations.

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