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Looking beyond the S&P 500: Time to refresh portfolios, benchmarks

Investors should broaden their focus beyond large caps, and advisers should ensure that their clients benchmark their portfolios correctly

Apr 3, 2019 @ 2:04 pm

By James Macey

An inflection point looms for investors, making it an excellent time for advisers and clients to consider some of the remaining fallout from the decade-long bull market — namely, an overreliance on the S&P 500 Index as both an asset class and benchmark. There is an opportunity for advisers to help clients get their portfolios sensibly positioned for what's ahead — and restore a proper reference for their investment goals.

The bull market has well rewarded large-cap investors. As of early March, the S&P 500 had returned approximately 16.4% annually over the past 10 years. The market also strongly reinforced an outsize focus on the S&P 500 as a good measuring stick for portfolios of all kinds, with help from relentless reference to the benchmark by the media as well as (unfortunately) common industry portfolio reporting practices.

In the fourth quarter of 2018, large caps faltered, with the S&P 500 registering its worst quarterly performance since 1931. But a curious dynamic emerged over the course of barely four months: Taking a look at the swing in the equity market on an absolute terms basis, the 19.4% loss at the trough was actually less than the 20.1% rebound at the peak.

(More: How mid-cap growth funds owned the first quarter)

Hence, although complacency may have settled into the background during the fourth quarter, it has returned with a vengeance since Christmas Eve. The S&P 500 has, indeed, rallied, but more market uncertainty is likely ahead, especially considering factors like declining global growth forecasts and trade tensions.

Such challenges underscore an urgent need for investors and advisers to assess portfolios and benchmarks with fresh eyes and reconsider the benefits of appropriate diversification — benefits that the large-cap run-up might have obscured.

Advisers can start by educating investors about the little-recognized volatility lurking beneath the S&P 500's surface. Since January 2015, the S&P's overall volatility has basically tracked that of its 50th least volatile stock, meaning that 450 or so of its constituents are more volatile than the index itself.

Volatility, naturally, can work both for and against an investor; however, when it's working against, the pain can be acute. For example, from January 2015 through February 2019, the S&P 500 was positive more often than negative (37 versus 13 months, respectively).

But the down months hit hard. During the October 2018 sell-off, the S&P 500 fell 6.8%, with many components experiencing large volatility spikes. It definitely argues for a more rigorous approach to managing large-cap exposure.

While simultaneously broadening investor focus beyond large caps, advisers should ensure that clients benchmark their individual portfolios correctly. A diversified benchmark is a more suitable measure for diversified portfolios going forward.

Advisers also should help clients apply such benchmarks with consistency, as many will remain prone to "conditional" benchmarking, shifting their basis for comparison to a more preferred benchmark as the markets change, tempting them to modify their expectations accordingly.

Storms may lie ahead, but advisers can do considerable good by steering clients past the S&P 500 and instead arming them with portfolios and benchmarks better matched to opportunities for optimal, long-term performance.

(More: Morningstar study says advisory clients are stuck on investment performance)

James Macey is director of multi-asset portfolio management at Foresters Financial.

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