Since 1994, the S&P 500-stock index, which represents a capitalization-weighted grouping of the largest 500 common stocks, has outperformed 85 percent of the country's money managers. Is the S&P 500 beatable? And is it a fair benchmark by which to judge the equity universe? According to Craig T. Callahan, chief investment officer at Meridian Investment Management Corp., the answers to those questions are, respectively, "yes" and "no."
"Yes, the S&P 500 index is beatable when small-cap issues lead the way," says Callahan. This is demonstrated by the stronger returns of the Russell 2000 index, representing those issues with a market capitalization of less than $1 billion, compared to the S&P 500 in certain time periods."But no, it is not a good benchmark because it is not a stable, steady representation of the universe of stocks from which managers select." Callahan's contention - and concern for investors - is that, if history repeats itself, most investors will have answered these questions incorrectly and made a costly change in their portfolio at the most inopportune time.
Historically, both the S&P 500 and the Russell 2000 have dominated the equity markets for defined periods of time. Consider the four-year period of 1979 to 1983, when investors heartily endorsed small-cap issues. The Russell 2000 had an annual return of 26.7 percent, while the large-cap S&P 500 lagged with a 17.3 percent return. The next three years, conversely, were dominated by blue chips, with the S&P 500 garnering a 15 percent annual return vs. 4 percent annually for the Russell 2000.
Together, the S&P 500 and the Russell 2000 provide money managers with the majority of their stock selections. The indexes do not perform in tandem, however, due to the vast differences in capitalization. The compound annual returns for both indexes are different, yet cyclical.
Prior to October of 1987, investors thought loyalty to the larger issues would offer them a safe haven. Instead, large-cap investors were betrayed during the crash, and disappointed by their failure to recoup afterwards. Small-cap issues rebounded more intensely in 1988 with a 24.9 percent return.
Due to the constant shifting of primacy between the S&P 500 and the Russell 2000, investors should mistrust the comforts of the current index cushion.
Here are two no-load, large-cap index funds with low expenses that have beaten the S&P 500's 31.95 percent average annual return over the past three years: Vanguard Tax-Managed Growth & Income (31.98 percent) and Vanguard Index Growth (34.31 percent).