Time for a Partial Separation From the S&P 500
Are there better opportunities outside the S&P 500?
Since the advent of index funds, there is a trend to invest in the S&P 500 as the sole equity investment.
Since 1994, there have been three major bear markets, and the losses were steep.
I contend here that going smaller is the better option if one wants to limit market volatility.
Introduction
Since 1994-2022, the S&P 500 has realized an annual total return of 9.63% (±19.70%). That is a nifty return on one’s investment. However, during that time, it has seen six years of negative returns, and those include three bear markets with steep losses. Those bear markets were 2000-2002, 2008, and 2022.
The Dot.Com Bubble during 2000-2002 was interesting in that several indices performed reasonably well. Those include the S&P Midcap 400 and the S&P Small Cap 600. 2008 was during the real estate meltdown, and pretty much all equity segments were wiped out. It was the second worst year for the stock market since 1793. 2022 was also an interesting historical year where pretty much everything went negative, and was also the worst bond market in US history.
Here, I want to examine whether it is possible to invest in smaller companies, and still limit my risk. I want to thank MFS for the use of their data, so I can test my theories.
Large Cap Data
As mentioned above, the S&P 500 has averaged an annual total return of 9.63% (±19.70%) since 1994-2022. Six years saw negative returns, and the aforementioned bear markets did a real number of investors' portfolios.
Bear Market Data
During the Dot.Com Bubble (2000-2002) we saw a total loss of -37.6%.
2008 saw a total loss of -37.0%.
2022 saw a total loss of -18.11%.
Risk Data
I would also like to supply some risk data for your consideration:
Average: 9.63% (±19.70%)
Up Markets: 16.72%
Down Markets: -19.64%
Sharpe Ratio: 0.48
Sortino Ratio: 0.56
Mid Cap Data
Here is data for the S&P Midcap 400 Index as a comparison:
Bear Market Data
During the Dot.Com Bubble, we saw a total loss of -0.2%
2008 saw a total loss of -36.23%
2022 saw a total loss of -13.06%
Risk Data
Risk data for the S&P Midcap 400 Index:
Average: 10.99% (±18.11%)
Up Markets: 17.62%
Down Markets: -11.15%
Sharpe Ratio: 0.58
Sortino Ratio: 0.64
Small Cap Data
Here is data for the S&P Small Cap 600 Index:
Bear Market Data
During the Dot.Com Bubble, we saw a total gain of 1.7%
2008 saw a total loss of -31.07%
2022 saw a total loss of -16.10%
Risk Data
Average: 10.27% (±17.18%)
Up Markets: 16.20%
Down Markets: -9.81%
Sharpe Ratio: 0.55
Sortino Ratio: 0.64
Separate Yourself from The S&P 500
I have been contending for years that merely investing in the S&P 500 is overplayed and overbaked. There is a whole class of large-cap equities that are not included within the S&P 500 that should be considered. Many are financially sound, have increasing revenues, and have positive earnings. Some even pay a dividend. I have written about those before.
With this data, it is very apparent that looking at small companies has a history of generating better returns with lower volatility. Besides, I like any investment that limits my losses when the larger market goes haywire.
Does that mean one should invest in just mid-caps or small-caps? That would be tempting, but I would never make that suggestion. I do suggest, though, that one include these asset classes in their overall investing strategy.
What I am proposing as an example is to invest 35% in large-caps, 35% in mid-caps, and 30% in small-caps. Let’s see what that looks like.
Bear Market Data
During the Dot.Com Bubble, we saw a total loss of -14.0%
2008 saw a total loss of -35.0%
2022 saw a total loss of -15.7%
Risk Data
Average: 10.40% (±17.74%)
Up Markets: 17.47%
Down Markets: -12.99%
Sharpe Ratio: 0.55
Sortino Ratio: 0.60
What About an Index That Measures The Entire Market?
The CRSP US Total Market Index is a broad-based index that tracks the performance of nearly 100% of the U.S. investable equity market, covering about 4,000 stocks across different market capitalizations and sectors. While one might think it will create some separation from the S&P 500, it allocates 72% of the assets in large-cap companies. Meanwhile, 19% of the index measures mid-caps, and the remaining 9% is reserved for small-caps. In my opinion, this is not enough separation from the larger companies, and the potential returns of investing in smaller companies have now been diluted. Here is the data.
Bear Market Data
The Dot.Com Bubble saw a total loss of -28.1%
2008 saw a total loss of -36.3%
2022 saw a total loss of -17.0%
Risk Data
Average: 10.02% (±18.71%)
Up Markets: 17.95%
Down Markets: -15.75%
Sharpe Ratio: 0.52
Sortino Ratio: 0.57
What are Some Good Indices to Consider?
There are a few ETFs that have outperformed the S&P 500 since 1999. Compliance prevents me from listing those here, so I will instead provide the corresponding indices on which they are based.
Large Caps
1. NASDAQ 100— 833.42%
2. Dow Jones Industrials Average—-550.98%
3. CRSP US Large Cap Index—494.73%
4. Russell 1000 Index—478.47%
Mid Caps
1. S&P Midcap 400 Index—794.63%
Small Caps
1. CRSP US Small Cap Index—705.84%
2. Russell 2000 Index—532.56%
3. Russell 3000 Index—473.61%
4. Russell Microcap Index—419.91%
NOTE: Past performance is not a prediction of future returns.
A Brief Comment About The NASDAQ 100
Before one enters a buy order for an ETF for the NASDAQ 100, I believe there is a word of caution warranted. On March 27, 2000, one would have realized an all-time high for their investment. That was during the height of the Dot.Com Bubble. It was not until February 25, 2015, that someone would have recovered all of their losses from that index’s collapse. That is a 15-year period where someone would have realized no gain in their investment. In the meantime, the S&P 500 had a total return of 471%, the S&P Midcap 400 had a total return of 253%, and the small-cap index had a total return of 207%.
What accounts for the outsized return of the NASDAQ since 1999? In 1999, the NASDAQ saw a realized total return of 95%. I remember that being a period when it was puzzling why anyone would invest money in these companies when they had no profits, no free cash flow, and terrible balance sheets. There are times, I wonder if that is happening again with the rush to AI. While the NASDAQ is listed as a General Sector Index, it is really heavy in technology stocks (51.6%) and all the boom-and-bust periods that it entails. The best I can suggest is buyer beware.
Since 1994, this is how the NASDAQ has performed.
Bear Market Data
The Dot.Com Bubble saw a total loss of -73.44%
2008 saw a total loss of -36.3%
2022 saw a total loss of -32.97%
Risk Data
Average: 12.10% (±36.31%)
Up Markets: 27.53%
Down Markets: -31.61%
Sharpe Ratio: 0.44
Sortino Ratio: 0.61
Notice that the Sharpe Ratio is lower than that of the large-cap index (0.48). That might give one pause from going all in on this index.
My Take
I have written other works showing that investing only in the S&P 500 is a risk that one generally should not assume. Proper allocation, even within the equity space, and a willingness to invest outside the traditional index is a preferred option. Of course, one needs to reserve space in their portfolio for other asset classes. These include, but are not limited to fixed income, international equities, real estate, commodities, and hedging strategies. Also, cash is a good thing too.
Flourish and Grow
References
As always, I want to thank MFS and Factset for their help.
Disclosures
Securities are offered through Avantax Investment ServiceSM, Member FINRA, and SIPC. Investment advisory services offered through Avantax Advisory ServicesSM.
These opinions are based on observations and research and are not intended to predict or depict
the performance of any investment.
This information is intended to be for illustrative purposes only and does not reflect any particular investment or investment needs of any specific investor.
The information is based on sources believed to be reliable; however, their accuracy or completeness cannot be guaranteed. These views should not be construed as a recommendation to buy or sell any securities.
The S&P 500 index tracks the shares of 500 large publicly traded companies in the United States. One cannot invest directly in the S&P 500.
The Russell 2000SM Index is an unmanaged market capitalization-weighted index measuring the performance of the smallest 2,000 companies in the Russell 3000SM Index.
The Russell Midcap Index is an unmanaged index that measures the performance of the 800 smallest companies in the Russell 1000SM Index, which represent approximately 26% of the total market capitalization of the Russell 1000SM Index.
The rates of return shown above are purely hypothetical and do not represent the performance of any individual investment or portfolio of investments. They are for illustrative purposes only and should not be used to predict future product performance. Specific rates of return, especially for extended periods, will vary over time. There is also a higher degree of risk associated with investments that offer the potential for higher rates of return. You should consult with your representative before making any investment decision.
Investments are subject to market risks including the potential loss of principal invested.
Diversification does not assure or guarantee better performance and cannot eliminate the risk of investment losses.
Asset allocation does not assure or guarantee better performance and cannot eliminate the risk of investment losses.
Past performance does not guarantee future results.
The securities of smaller, less-known companies may be more volatile than those of larger companies.
An investment cannot be made directly into an index.