When it comes to the performance measurement of the stock market, the S&P 500 is considered to be one of the most widely followed and accepted benchmarks.  The interesting thing about the S&P 500 is that it is a market cap based index, i.e. the bigger the company the more influence it has on the index.

The top 10 holdings in the S&P 500 account for almost 20% of the weighting in the index – the top 10 names are:

 

Exxon Mobil

Microsoft Corp

Wal-Mart Stores

Google Inc’A’

Apple Inc

Johnson & Johnson

Procter & Gamble

Intl Bus. Machines

AT&T Inc

JPMorgan Chase & Co

 

As a matter of fact the top 38 issues account for 50% of the weighting in the S&P 500.  That means 462 companies account for the rest – perhaps it should be called the S&P 50… oh wait we already have the Dow Jones 30, couldn’t have two indexes too similar, how would the publishers differentiate themselves.

If we were to take a look at performance of the S&P 500 – the top 10 stocks that have attributed the most return to the S&P 500, you would expect in a market cap weighted index that they would be some of the largest names. Low and behold 5 of the names are the same, with the other 5 names in the top 20.

 

Google Inc’A’

Genl Electric

Berkshire Hathaway’B’

Procter & Gamble

JPMorgan Chase & Co

Chevron Corp

Pfizer, Inc

Johnson & Johnson

Exxon Mobil

Philip Morris Intl

 

Now I wonder what the overlap is for the top year to date performers in the S&P 500:

 

Constellation Brands’A’

Safeway Inc

Hewlett-Packard

Heinz (H.J.)

Sealed Air

Cabot Oil & Gas

Tesoro Corp

Avon Products

Computer Sciences

Range Resources

 

Whoops there isn’t any.

Now the risk you take as an asset manager is that if you are being benchmarked against the S&P 500 – you better own the top handful of names – you can’t afford to be wrong on your own.

However, if you are looking for some businesses that seem to be doing well in a turbulent economic environment, perhaps looking into the index data could become a fertile ground for stock selection.

This post wasn’t to disparage the use of the S&P 500 as a benchmark or an investment vehicle but to highlight the fact that with a little bit of “scratching” a lot of data can appear.

That’s it from me and bye for now.

 

*All index data mentioned here was sourced from:

http://www.standardandpoors.com/indices/sp-500/en/us/?indexId=spusa-500-usduf–p-us-l–

One of the core principles of the asset management industry is diversification and asset allocation. You want to own a portfolio of differently correlated investments, i.e. when one zigs the other should zag.

A critical component of this is the correlation coefficient between two variables. Correlation is measured between -1 and  +1.  Perfectly negatively correlated (-1) ,ie for a 1% increase in a variable expect a 1% decrease in the other variable and perfectly positively correlated (+1), ie for a 1% increase in a variable, expect a 1% increase in the second variable. The closer to zero the less correlation.

For diversification to work well, some investments may be losing money – whilst others are making money. This usually leads to the conversation of “why don’t we sell some of the losers and buy more of those that seem to be making money”, this could be construed as selling low and buying high… The blight of investor biases.

Onto the math (yah).

Traditional asset allocation says that a portfolio of equities is diversified if you have large company (Large Cap) stocks, mid sized company stocks (Mid Cap), small company stocks (Small Cap) International and Emerging Market stocks.

So you would hope that the correlation coefficients for these variables would be around 0.6 – 0.7, ie 30-40% of the time they will have a different path of returns.

I looked at the following investments to see what their correlations were over the last three years and also their longest common time period (since 04/08/2003):

iShares S&P 500 (IVV), iShares Mid Cap (IJH), iShares (IJR), iShares MSCI EAFE (EFA) and iShares MSCI Emrging Markets (EEM).

The data is presented in a chart – and shows the correlation between two different investments, just match the column with the row and there is your number!

Correlation Over the Last Three Years

You can see very high correlation between the 3 US equity investments (0.898-0.959), with the greatest diversification being the addition of the emerging markets.

Longest Common Time Period, since 4/8/2003

Again you see very high correlation between the US Investments and the greatest diversification benefit being offered by the Emerging Markets.

What does this mean to the investor – given these high levels of correlations, all of these investments are behaving as one asset class, not five.  If 60-70% of your portfolio is in these investments you are not as diversified as you may think.

This isn’t necessarily a bad thing – it’s just that most people are unaware of the high degree of correlation between their investments.  This is true more so today than other times, where we live in a world of “Risk On” and “Risk Off” investing because of the role and influence of central banks flooding the world with liquidity and making it very difficult for investors to make decisions, because of the outsized role of government in most major economies.

Today we have to be very cognizant of the risk in our portfolios and make decisions accordingly.

This was a bit of a “wonkish” post – maybe next time we can talk about something more entertaining – perhaps beer?

Bye for now.