The Fortune 500 is superior for measuring the performance of U.S. large-cap stocks.

Investment professionals have traditionally regarded the Standard & Poor's 500 Index as the best proxy for U.S. large-cap blue-chip stocks. In recent years, however, investors have become increasingly discriminating about the indexes they use to benchmark the performance of particular asset classes. Those seeking a proxy for U.S. large-cap blue-chip stocks have become concerned that the S&P 500's composition and performance have become too volatile to represent a stable segment of U.S. large-cap blue-chip stocks.

In a recent study, we compared and contrasted the composition and performance of the S&P 500 and the Fortune 500 indexes to determine whether one offers a superior alternative for measuring the performance of high-quality, less volatile blue-chip stocks. We reviewed their rules of maintenance and construction, recent composition and historic performance.

We found that the Fortune 500 is superior to the S&P 500 as a benchmark for U.S. large-cap blue-chip stocks. The Fortune 500 index has enjoyed a higher return and lower volatility since its inception, while providing a diverse universe of blue-chip stocks. Furthermore, the S&P 500's composition reflects a rather systematic bias toward companies having more volatile earnings and market capitalization. That may be a root cause for the senior index's higher standard deviation.

Fortune 500 Index

The Fortune 500, introduced on a real-time basis in December 1999, is a capitalization-weighted index that measures the performance of the largest U.S. companies ranked by revenues. The index is derived from the Fortune 500 List, which was introduced in 1955. Each year, the list is compiled from the latest reported financial data as of January 31 through the efforts of teams of reporters, accountants and analysts gathering data, organizing and analyzing the information, and then releasing a list in April each year. The list consists of the 500 largest domestic U.S. companies ranked by total operating revenues, as reported in their latest fiscal year, including revenues from discontinued operations. The revenues for commercial banks and savings institutions are the sum of interest and non-interest revenues. Those for insurance companies include premium and annuity income, investment income, and capital gains or losses, but exclude deposits.

Components for the Fortune 500 are selected from the Fortune 500 List based on four eligibility criteria:

1) A stock must be publicly traded on the New York Stock Exchange, the American Stock Exchange or the Nasdaq National Market.

2) It must have a minimum average daily trading volume of 100,000 shares during the 25 consecutive trading days preceding initial inclusion.

3) It must have a minimum reported price equal to or in excess of $5 per share during that period.

4) The company must have a minimum market capitalization equal to or in excess of $100 million during that period.

The criteria used in compiling the Fortune 500 are rigorously followed by the Fortune Index Committee, resulting in the index being objectively derived and completely transparent with respect to its constituents. The index requires little maintenance because components removed are not replaced. A company may be removed during the year if it violates any of the eligibility criteria. Similarly, a company may be added if has an initial public offering and meets the eligibility criteria. Once removed, components may be considered for re-inclusion in the index the next year during annual reconstitution (which occurs after the close of trading on the third Friday in April following publication of the Fortune 500 List), provided these companies are on that year's Fortune 500 List. Year-to-year maintenance is minimal due to the index's low turnover, a result of companies able to produce large revenues in one year and repeating the feat in subsequent years. According to Fortune Indexes, the Fortune 500's annualized market capitalization turnover was 4.34% from 2000 to 2002.

Since only public companies meeting the eligibility criteria are selected from the 500 list, the index ordinarily contains fewer than 500 components. Because the index committee does not replace components removed because of rule violations, the index usually ends each year with fewer components than when it began. For example, the index began its year with 443 components on April 23, 2001, dropped 23 and ended its year with 420 on April 19, 2002. A few days later, on April 22, 2002, at annual reconstruction, the index included 451 companies, which were reduced to 441 by June 30. However, as mentioned earlier, certain corporate actions, such as initial public offerings and spin-offs, have the potential of increasing the number of components in the Fortune 500 throughout the year.

S&P 500 Index

The S&P 500 index has had a long tenure as a stock market indicator. Seeking to portray the average experience of those investing in U.S. stocks, Alfred Cowles pioneered the index's methodology beginning in 1913. His original study was designed to calculate the average price change and other related statistics for a cap-weighted basket of all stocks listed on the New York Stock Exchange beginning in 1871-a Herculean task, given the paucity of computing resources available. His efforts led to the development of the forerunner of the S&P 500 index in 1923, when Standard & Poor's introduced a new methodology for evaluating stock performance called the "base-weighted aggregate technique" and a series of indexes that included 233 companies grouped into 26 industries.

Today, the S&P 500 is still cap-weighted, but is limited to 500 stocks in 10 economic sectors. According to Standard & Poor's, "The 500 companies chosen for the S&P 500 Index are not the largest companies in terms of market value, but rather, tend to be leaders in important industries within the U.S. economy."