Forget the S&P 500 -- Can You Beat the S&P 600?

Why you could be using the wrong benchmark for your portfolio.

Jul 11, 2014 at 1:17PM

You might track your portfolio against the S&P 500 (SNPINDEX:^GSPC), but what about the S&P 600? If your stock picks are geared toward long-term, market-beating returns with an emphasis on selecting premier small-cap stocks, the S&P 600 could be the benchmark you're actually looking to beat. And if you can't top it, you may want to consider taking up some shares of a well-allocated small-cap index fund.

Why the S&P 600?
While there are numerous candidates for a solid small-cap benchmark, including the Russell 2000, the S&P 600 is a superior choice. First, let's examine the historical returns of both the Russell 2000 and the S&P 600. Since 1994, the Russell 2000's annualized return has been 9.3%, while the S&P 600 has returned 11.1%.

This may be partially explained by the process of stock selection for the indexes. The Russell 2000 index is rebalanced annually to constitute the 2,000 smallest companies within the Russell 3000 index. Due to both upward and downward pressures as stocks are added to and subtracted from the Russell 2000, there may be consistent losses. One study found that a buy-and-hold portfolio based on the Russell 2000 index outperformed the rebalanced index from 1979 to 2004 by an average of 2.22% over one year and 17.29% over five years.

The S&P 600, meanwhile, is determined entirely by a committee vote. The committee requires that candidates for the S&P 600 post four consecutive quarters of positive earnings. A Foolish investor should love this requirement, which favors companies poised for rapid, sustainable growth. The disparity between the two indexes is even more evident when examining the percent of companies posting negative earnings. From 1997 to 2000, 16% of companies in the Russell 2000 never reported positive earnings, compared to 1.5% of companies in the S&P 600. In 2012, the difference was smaller, but still significant: 12% for the Russell 2000 and less than 5% for the S&P 600.

S&P 500 vs. S&P 600
If a large percentage of your portfolio comprises small caps, tracking performance against the S&P 500 is probably not the best benchmark for you. How different can the S&P 600 be? Well, over the past 10 years, the S&P 600 has almost doubled the S&P 500's returns, 134% to 76%.

^GSPC Chart

^GSPC data by YCharts.

Also consider that $1 invested over the 30 years from 1975 to 2005 returned $88.50 if invested in small-cap stocks, $65.30 if invested in mid-cap stocks, and $32.70 if invested in large-cap stocks. On the whole, small-cap stocks are much higher in risk and volatility. However, the market rewards investors who can stomach the higher peaks and lower troughs better than investors who seek out low volatility and security.

Off to the races?
Don't scramble to exchange your carefully crafted portfolio for small-cap funds just yet. The S&P 600 may have dominated the S&P 500 from 2000 to 2014, but this is not necessarily an indication of future performance, especially in the short term. Apple, a longtime large-cap and what some now call a megacap, has put even the S&P 600 to shame. From 2000 to 2014 would have returned an impressive 7,525%. Lastly, your personal time horizon for investing is a crucial consideration when looking at small-caps. For any class of equities, mid caps and large caps included, a good rule of thumb is to only invest money that you will not need for at least five years. Because small caps are much more volatile, it may take longer for a small-cap index to recover from a steep decline. If you don't have the time or the stomach to weather the ups and downs, perhaps look at less volatile investments. Understanding how the higher level of risk figures into your overall financial planning is essential.

Where to look next
If you find that your portfolio has indeed beaten the S&P 600 over the long term, that you're nearly there and hope to use your increasing financial education to get the best of the index, then keep these musings on small-cap index funds far in the back of your mind. If you have read this far, however, and find this sort of investing to be right for you, then you may want to look into the various mutual funds and ETFs that track the S&P 600 or other small-cap indexes. Vanguard, SPDR, iShares, and others all offer funds that closely track the performance of small-cap indexes, some with a tilt toward value or growth to suit your fancy. Always examine the expense ratio of a given fund to ensure that you're not overpaying. For reference, Vanguard offers its S&P Small-Cap 600 ETF (NYSEMKT:VIOO) for an expense ratio of 0.15%.

If the increased volatility and risk of small-cap indexes don't suit you, keep in mind that the S&P 500 is a famed benchmark for a reason. Index funds based on the S&P 500 can serve as a solid backbone for a portfolio or provide a good starting point for beginning investors. The SPDR S&P 500 (NYSEMKT:SPY) ETF, the Vanguard S&P 500 ETF (NYSEMKT:VOO), and the iShares Core S&P 500 (NYSEMKT:IVV) ETF are all strong choices for low-cost ETFs that closely track the performance of the S&P 500.

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Fool intern Grant Heskamp has no position in any stocks mentioned. The Motley Fool has no position in any of the stocks mentioned. Try any of our Foolish newsletter services free for 30 days. We Fools may not all hold the same opinions, but we all believe that considering a diverse range of insights makes us better investors. The Motley Fool has a disclosure policy.

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