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4 Reasons to Stop the S&P 500 Comparisons

Noah Smith is a Bloomberg View columnist. He was an assistant professor of finance at Stony Brook University, and he blogs at Noahpinion.
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It has become fashionable to compare every financial asset, asset manager or investor to an index of U.S. stocks. For example, many people compare hedge funds to the Standard & Poor's 500 Index. We saw this recently as people discussed whether Donald Trump’s business career has been more successful than an investment in the S&P 500. As my Bloomberg View colleague Matt Levine points out, this isn't an apples-to-apples comparison. 

But actually, very few comparisons with the index are apples-to-apples. This practice grew out of an admirable impulse, but it has gone too far. 

The idea of comparing returns to an index is loosely based on decades of financial research. Essentially, it comes from the logic of efficient markets. If markets are close to efficient, then very few investors will achieve above-market returns on a consistent basis without accepting some cost for doing so, such as higher risk or lower liquidity. In other words, an average of all assets -- i.e., a value-weighted index such as the S&P 500 -- gives you the best risk-return tradeoff you can hope for. 

This logic -- and the huge body of empirical research that generally supports it -- has been incredibly important for the average investor, and for the money management industry. It has resulted in the rise of passive asset management and the creation of index funds and exchange-traded funds (ETFs). It has spawned movements like the Bogleheads, who follow the wisdom of Vanguard Group founder John Bogle and avoid trying to pick stocks. 

But when we compare things to the index, we go beyond that simple logic, and we end up making bad comparisons. Here are four reasons why even in a world of efficient markets, we can expect portfolios or money managers to have returns that are different from the index: 

1. Risk. Portfolios with less risk can be expected to earn lower returns on average. That’s why Treasury bonds usually return less than stocks. People still buy Treasuries, because the low risk of Treasuries is compensation for the fact that they don’t tend to go up as much as other assets. Leverage also creates risk, but can increase expected returns. 

Now, here’s the catch: We don’t have a good model of risk. In theory, risk should be related to how exposed assets are to broad movements in the market and the economy. But exactly what those factors are is something we still don’t really know. The most popular model, the capital asset pricing model, says that risk can be captured by “beta” -- roughly, returns that swing up along with the index. But this model doesn’t work very well in practice, and there’s no consensus on what should replace it. So if you see some manager or asset class doing worse than the S&P 500, it might be because it avoids risks that you don’t even realize exist. 

2. Liquidity. If you can’t sell an asset without triggering a fire sale, then your asset isn’t worth as much as it looks on paper. The ability to sell without moving the price is called “liquidity.” There are many ways of measuring it and many factors that affect it, but it’s clear that liquidity affects returns. Very illiquid assets should be compensated with higher average returns -- and this is what we see happening

So if you see an asset manager whose portfolio consistently beats the index, you might want to ask how liquid his or her investments are. Many of Donald Trump’s assets are in real estate, which isn't very liquid. It is difficult to sell Trump Tower quickly without cutting the price. So we would expect Trump to earn a return that, on average, beats the index. 

3. Correlation. When we talk about “the index,” we usually mean an index of U.S. stocks, such as the S&P 500. But although U.S. stocks might have been the main risk asset available to investors in 1915, they are only one small part of a huge universe of such assets in 2015. There are international stocks, high-yield bonds, real estate, commodities and much more. 

This means that “the index” isn't the true index of the entire market. It’s not even close. And all those other types of investable assets are only partially correlated with U.S. stocks. If an asset class has a very low or negative correlation with U.S. stocks, it may well have a very low average return, since people would want to buy it simply as a hedge against the possibility of a U.S. stock market crash. 

In general, this means that if you’re making an index comparison, at least try to compare similar asset classes. For example, Trump, a real estate investor, should probably be compared not with the S&P 500, but with some index of real estate investment trusts (REITs). 

4. Mean reversion. We know that the prices of stocks and other risky assets tend to bounce around more than their long-term fundamental values. These mispricings can take a decade to correct themselves. So if you see a portfolio of stocks that has beaten the index for five years, there is a better than average chance this outperformance will reverse itself during the next five.  

So there are many reasons why an asset manager, a portfolio of stocks, or a businessperson like Trump shouldn’t simply be measured against the S&P 500. The only thing you should really measure against the S&P 500 is a portfolio of stocks in the S&P 500. And even then, you should take things like risk and liquidity into account. Index comparison is fun, but it isn't always very meaningful.

This column does not necessarily reflect the opinion of the editorial board or Bloomberg LP and its owners.

To contact the author of this story:
Noah Smith at nsmith150@bloomberg.net

To contact the editor responsible for this story:
James Greiff at jgreiff@bloomberg.net