What’s Your Benchmark?

How did the market do today?

Whether it’s NPR, the Wall Street Journal or small talk with your neighbor, most conversations about the stock market and economy inevitably reference either the Dow, NASDAQ or S&P 500. But are they appropriate measurements? What do they actually track? And most importantly, are they appropriate measure of performance?

The investment benchmark industry is big business. Though there are thousands of benchmarks or indices, this post will focus on the big 3: Dow Jones Industrial Average (the Dow), NASDAQ and S&P 500.

This 2-part blog will:

1. Provide an overview of popular benchmarks
2. Provide takeaways when assessing performance

US Stock Market Benchmarks: Tale of the Tape

Key Differences

Objective

All three benchmarks vary in their objective. The Dow’s goal is to provide a broad gauge on how the US stock market is doing. While it has constituents in every sector of the market excluding utilities and transportation, only tracking 30 companies limits its ability to provide an accurate measure of the market as a whole considering there are more than 3,500 publicly traded companies in the US stock market.

The S&P 500’s goal is to provide a measure of the US companies in the “large-cap” space. Of the US stock market, large-cap companies make up roughly 80% of all companies.  A companies’ cap-weighting is calculated by multiplying the outstanding shares times the stock price.

For context, let’s compare two companies at the opposite end of the spectrum. Apple has a market-cap of roughly $1.9 trillion and Ralph Lauren’s market-cap is $5 billion. To be included in the index, companies must maintain a market-cap weight of $4.1 billion. The S&P 500 is a great barometer for its target space of large US companies, but all too often is incorrectly used to quote “the market.”

The NASDAQ benchmark doesn’t have a formal objective like the other two and is only intended to measure the performance of all companies listed on the NASDAQ stock exchange. While is spans many industries, it has a much larger concentration in technology companies making it the de facto benchmark when discussing the performance of technology stocks.

Index Weighting: Market-Cap vs Price

How an index is calculated plays in an important role in determining the performance of the index. The S&P 500 and NASDAQ are cap-weighted indices and the Dow is price-weighted. What’s the difference?

For a price-weighted index, the share price of the stocks determines the weighting within the index. Therefore, the higher the share price of a stock relative to the other stocks, the greater impact on the performance of the index it will have. Although a company’s stock price is an input into calculating its market-cap, it only tells half the story and often overweighs the performance of a company with a lesser economic footprint.

A cap-weighted index avoids this drawback by deriving its performance from the movement of the underlying holdings multiplied by their respective allocations as determined by market cap.  For context, using the companies listed earlier, Ralph Lauren makes up roughly 0.1% of the S&P 500, while Apple makes up almost 7%. This method is more common among benchmarks tracked by index funds.

Reconstitution

In the investment management world, reconstitution refers to the process of an index reshuffling the list of companies they’re going to track. It typically involves removing companies that no longer fit the bill and replacing them with those that do.

The Dow doesn’t have a formal method outlined by quantitative measures and can reconstitute at any time. Typically, changes are made in response to corporate actions or market developments.

The NASDAQ simply tracks the companies on the exchange, removing any judgement or analysis.

The S&P 500 has a much more systematic approach and is the most closely tracked of the three. Due to the increased popularity of passive investing, there are hundreds of index mutual funds or ETFs that track the S&P 500. Because of this, the quarterly reconstitution causes increased trading of those securities involved which can lead to some drawbacks for index investors (more on that in the next post).

Conclusion

All three benchmarks are used interchangeably but have distinct differences. The next post will offer a different perspective and provide a more robust method for assessing the stock market and performance of your investments.