A benchmark for the S&P 500

It is ironic that the most important passive index in the world--the S&P 500--is, in fact, managed. For example, the minimum eligibility requirement is now a market capitalization of $22.7 billion; yet 29% of current members fall below this threshold. A committee decides what to include or exclude to minimize turnover, with enough mystery to prevent hedge funds from front-running adds and deletes.

The question for investors is what this subtle form of active management achieves compared to a purely mechanical index of the top 500 stocks by market capitalization. Are S&P 500 constituents better performers than the simpler top 500? Market-cap weighting obscures the behavior of individual stocks, whereas equal weighting offers a clearer lens.

The top chart, which displays the equal-weighted returns of the stocks of the top 500 companies by market capitalization relative to the equal-weighted S&P 500, shows that the equal-weighted top 500 and the equal-weighted S&P 500 have taken turns outperforming each other. The COVID-19 market shock in March 2020 sparked sharp outperformance of the top 500, followed by two years of favoring S&P 500 constituents. Over the past two years, however, the top 500 have steadily done better.

This difference matters for factor returns. Consider the low-volatility factor shown in the bottom chart. Sector-neutral long-short portfolios based on low volatility for S&P 500 stocks have performed poorly over the past five years. In contrast, the same factor applied to the top 500 has behaved quite differently — sometimes resembling the S&P 500's low-volatility factor performance, other times diverging meaningfully.

For investors, comparing the equal-weighted versions of the S&P 500 and the top 500 by market cap shows how much "passive" investing depends on committee choices. As the low-volatility example illustrates, that distinction can materially reshape factor returns.