We conduct a lot of GIPS(R) (Global Investment Performance Standards) verifications, and often see managers use the S&P 500 as the benchmark for their composite. But this is often the wrong one to use.

For GIPS purposes the index should tie into the composite’s strategy. The Standards’ glossary defines benchmark as “an independent rate of return (or hurdle rate) forming an objective test of the effective implementation of an investment strategy.” Would the S&P 500 serve as such a test for a US growth equity manager? Hardly, since half the index consists of value stocks which presumably wouldn’t be in the manager’s radar. The benchmark should be a way to judge how well the manager did, but a broad index doesn’t properly serve this purpose.

Back in January 2000 a large mutual fund manager ran full page advertisements reporting how several of their funds had outperformed the S&P 500, and they provided the proof right there in the ad! However, the ad included funds that invested in small cap, European stocks, emerging markets, etc.; i.e., strategies which clearly didn’t align with the S&P 500. While the ad seemed to imply that their funds had done well because they beat the S&P 500, in reality the sectors they were invested in may have beaten this index, and the mere fact that these funds were invested there caused them to also have higher returns. The test of the investment strategy would have been to compare the funds with individual indexes that aligned with each fund’s individual strategy.

But does this mean that it would be wrong to show the S&P 500 in a composite, if the strategy doesn’t align with this benchmark? Not necessarily. If there are no benchmarks that match the strategy, you may want to show a variety of indexes, including the S&P 500, to provide the reader with some comparative information, but you’d want to include an appropriate disclosure explaining why you’re doing this. The manager isn’t managing against the S&P 500, and therefore any out-performance can’t be attributed to decisions to “beat” this benchmark. The manager may simply be invested in securities or sectors that aren’t in the S&P 500, and by virtue of their idiosyncratic performance the manager is meeting with success (or failure).

Even if you do have a benchmark that matches your strategy, many managers still want to show the S&P 500 (along with the strategy benchmark) for comparison purposes: not to say “heh, we beat the S&P 500” but simply because this index is viewed by many as “the market.”  But if you do this, you should explain why you’ve included this index to avoid any confusion.

Many clients want to see the S&P 500 on their reports as well as other broad market indexes, for comparison purposes, not as a “test” of the manager’s success at implementing their strategy, since this index fails to do this. This is perfectly fine, too.

p.s., I recall meeting with a growth manager a few years ago who explained that he had previously used the S&P 500 as the index, but lately it hadn’t done so well. Could it be that during the ’90s, when growth was “all the rage,” the value portion of the S&P 500 was dragging its performance down, while the manager didn’t have such an encumbrance, but when the “tables were turned” and value was beating growth, the S&P 500 was now outperforming the manager and therefore didn’t look so good? The S&P 500 was never the right index for this manager.