On the economic significance of the benchmark portfolio

Abstract

A basic issue underlying financial theory is the constitution of the "market portfolio" M. Hence the adequacy of its usual proxy, the S&P500, is of paramount importance. Using 17 industry portfolios, we form an equally-weighted (passive) portfolio statistically identical to the S&P500 with respect to volatility. We find that, about half the time, the industry portfolio has higher returns than the S&P500. We offer this as an explanation for the flatness of the CAPM noted and questioned in early studies by Basu (1977), Black, Jensen andScholes (1972), andReinganum (1981). We suggest that the partial inefficiency of the S&P500 is laden with serious implications for investors and portfolio managers, question the behavioral motivation for its continued use as a benchmark, and introduce new measures of full diversification. We estimate a Jensen's Alpha error of 2.04% associated with the wrong proxy for the market portfolio. Requests for proper benchmarks against which to measure performance are pervasive in the finance industry, because benchmarks have two critical uses. First, investors need to be able to evaluate performance. Second, managers may be compensated according to the "alpha" that they earn. That is, they are paid to outperform a benchmark after adjusting for risk.A basic issue underlying most of financial theory is the constitution of the "market portfolio" M. In theory, M is a portfolio comprised of all tradable assets and does not have a tangible existence. Hence the adequacy of its usual proxy, the S&P500, is of paramount theoretical as well as practical importance. Although the most recent 10 years is clearly a unique period of financial history, the recent lackluster returns may not be a direct result of these specific recent events. In spite of the cautionary recommendations of academics like Wharton's Jeremy Siegel (cf. Tergesen, 2005: 100), investors still rely more on exemplary indices than broader diversification. That is, market performance is generally measured through broad-based market indices such as the Standard & Poor Index (S&P500), the Dow-Jones Industrial Average (DJIA) and the Russell-3000; yet the extant literature leaves a question about the appropriateness of these indices in the context of efficiency.In this paper, we pose two basic questions: "Do major market indices fall on the efficient frontier, and, if not, what causes the continued benchmarking against them?" These questions are critical for portfolio managers because linking performance to a totally (or even partially) inefficient proxy for the market portfolio has serious implications not only for themselves, but also for the trillions of investment dollars pegged to major-index performance.