Why You DON’T Want to Load Up on The S&P500

The most popular of all market indices, the S&P500, which is made up of the 500 largest domestic public companies, just hit an all-time record high. It is up around 3.5% Year-To-Date (through May 13, 2014) and also is outperforming most of the other equity investment styles, i.e. mid cap, small cap, international, emerging in that same time period. So what’s not to love about it?!?

Whereas our DWM Core Equity Model currently has about a 35% weighing in large caps, we have received a few questions about why our models don’t have more. Several questions have also arisen about why we have the allocation that we do toward small caps, which have suffered so far this year, down over 3%.

There are a few main reasons which I’d like to explain here:

  1. U.S. large caps stocks alone do not provide appropriate diversification – We constantly are preaching about asset allocation and how by adding multiple asset classes one can bring non-correlation benefits to your overall portfolio, which produces a smoothing effect to the return profile, minimizes the downside, and ultimately leads to better long term results. The same concept applies within an asset class. So the more investment styles within equities – large cap, mid cap, small cap, international, emerging – the better, thus ultimately leading to better long term results.
  1. The biggest factor in investor under-performance is from chasing returns; i.e. buying after a streak of hot performance and selling off after a period of weakness. So don’t get caught up in the “investment style du jour”. Large caps are in vogue right now, but that certainly is not always the case. Take a look at the chart below.

Randomness of Returns

As this chart depicts, in both US and non-US markets, there is little predictability in asset class performance from one year to the next. Studying the annual data in the slide reveals no obvious pattern in returns that can be exploited for excess profits, strengthening the case for broad diversification across many asset classes. Investors who follow a structured, diversified strategy are more likely to capture the returns wherever they happen to occur.

That being said, over the past 50 years, academic research has identified variables that appear to explain differences in average returns among stocks. The variables (or premiums) that have stood up to rigorous testing are considered dimensions of expected returns. One of these dimensions is “size effect”. In 1981, Rolf Banz observed that small company stocks tended to have higher returns than large company stocks, as measured by their market capitalization. The size effect provided a more detailed framework for understanding the dimensions of equity performance. No one is certain why small cap stocks have offered an average return premium over larger cap stocks, but many economists assume that markets rationally discount the price of such securities to reflect higher systematic risk.

The chart below shows that this small stocks size effect premium is actually quite significant, leading to an increased annual return of 3.58% since 1927.

US Size Premium

So what’s not to love about small caps then?!? The small cap premium is great, but one can also see that this size premium is neither consistent nor predictable, as the chart above demonstrates. Another reason why we chose not to load up in any one area but to diversify. Therefore, a minority allocation of 15-25% of your total equity portfolio may be appropriate for small caps.

In conclusion, don’t get caught up in the latest fad and chase short-term outperformance by putting all your marbles in one basket such as the S&P500. Instead, think long-term and diversified. Diversified global investors who maintain a long-term outlook are the ones that are rewarded.