When people discuss “the market”, what exactly are they referring to?
Thankfully, the Dow Jones Industrial 30 average, with its numerous shortcomings is used less and less as a broad proxy for the overall market. These days the go-to benchmark for stock market performance is the S&P 500 index. But how much of “the stock market” does the S&P 500 really cover?
The S&P 500 is a market-capitalization weighted index of 500 U.S. based companies, selected by a committee to broadly represent the U.S. economy. Since the index is cap-weighted there is definitely a large-cap bias to it. The top 10 names out of 500 make up 17.61% and the top 25 names equate to 32.53% (Source: Morningstar Direct. As of 12/29/2015). However, for the purposes of this post, what is more important is what is NOT included in the S&P 500.
By design, the S&P 500 does not include small cap companies or non-U.S. based firms. In the pie chart below we see the market capitalizations of the world’s equity markets. While the S&P 500 counts for a significant chunk of the world markets at $18.3trn, it is, in fact, a minority of the world portfolio.
As of November 30th, the mid cap and small cap markets account for $2.2trn dollars. The developed international markets are almost as large as the U.S. markets at $17.4trn. In spite of their recent woes, emerging markets are still significant at $3.9trn.
All told, there is $23.5trn, or 56.2% of the world’s equity markets not represented in the S&P 500. (Source: Zephyr AllocationADVISOR)
Does that matter? Certainly from a portfolio construction standpoint it seems logical that an investor would desire to have as many “tools in the toolbox” as possible. Intentionally limiting one’s opportunity set to only large cap U.S. investments seems narrow-minded and self-defeating.