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."

The S&P Index Committee governs the index's composition to maintain the S&P 500 as an appropriate benchmark for the performance of the U.S. equity market. Before 1982, the committee's primary function was to find replacements for companies that filed for bankruptcy protection or ceased to exist because of merger-related activity. Since then, the committee has tried to maintain "a flexible approach to managing the index ... The Committee does not establish a rigid set of rules that must be followed without concern for impact on the marketplace ... Maintaining stability of the population of companies within the S&P 500 Index is of primary consideration. Excess company turnover impacts the statistical validity of the Index as a gauge of Market performance."

Notwithstanding the stated intentions of the S&P Index Committee, considerable debate persists on whether the S&P 500 is any longer an appropriate asset class proxy for big companies in the U.S. stock market. Since the 1960s, the vast majority of academic and institutional studies have used the S&P 500 as the benchmark most suited to representing the U.S. stock market. Today, we evaluate the extent to which this choice is still appropriate.

Evaluation Criteria

Establishing precise criteria to intelligently evaluate and identify the best available proxy for large U.S. stocks is critical. One cannot evaluate what one cannot measure. We evaluated the indexes based on five criteria that compare their relative merits as asset class proxies for today's U.S. large-cap blue-chip stocks. They are:

1) consistency and objectivity;

2) composition;

3) economic-sector diversification;

4) market capitalization: size, range, average and median stocks;

5) performance (returns and risk) .

Consistency And Objectivity

Consistency and objectivity are required to minimize subjective selection biases, such as sector and industry exposure, market cap and so on. Consistency requires that the selection process be implemented in a disciplined manner, regardless of the time period. The standards for inclusion in 1990 should be no different than the standards of inclusion in 2000 or 2010. Objective and unambiguous inclusion criteria make it possible to perform statistically valid back-tests without survivorship bias because all companies that existed at a historical point in time can be measured and selected according to an objective standard.

In the early 1990s, Standard & Poor's attempted to perform a back-test of its new index, the S&P MidCap 400, but had no objective criteria established for selecting stocks that would have been included prior to the base date. Since it had no objective criteria and standards held by committee members varied with time, historical index values for the 400 stocks could not be computed. Instead, historical price data for stocks initially selected were used to measure the index's historical returns for the ten-year period preceding its introduction. However, many of those stocks did not exist for the full ten-year period. In fact, many of them began the back-test period as micro-cap stocks with less than $100 million in market capitalization, issues that never would have been selected for the MidCap index in 1981.

More recently, on July 19, 2002, S&P's Index Selection Committee conducted a major rebalancing of the S&P 500 in an attempt to better capture the U.S. large-cap stock universe. It removed seven non-U.S. domiciled stocks from the index, some of which had been included for decades: Royal Dutch Petroleum, Unilever NV, Nortel Networks, Alcan, Barrick Gold, Placer Dome and Inco. It replaced them with seven large-cap, high-profile stocks, some of which had been ignored for years: United Parcel Service, Goldman Sachs Group, Prudential Financial Group, eBay, Principal Financial Group, Electronic Arts and Sungard Data Systems. One can therefore question whether, prior to the recent rebalancing, the S&P 500 truly represented U.S. large-cap blue-chip stocks.

In contrast, there is little ambiguity or subjectivity in selecting components for the Fortune 500. The list from which they are drawn is objectively determined, requiring only that companies be ranked according to revenues, which are determined by a fixed definition and specific rules. The rules by which components are selected from that list are also rigorously defined and applied, as are the rules for removing a company. In sum, the process of creating the Fortune 500 is both consistent and objective, resulting in a completely transparent index irrespective of the historical point in time it is selected.

Index Composition

The most obvious difference between the S&P 500 and the Fortune 500 is that the former always contains 500 issues and the latter fewer issues when it is initially constructed each year. Since the Fortune 500 does not replace components that are removed, it typically will have fewer components by year-end.

The two indexes' monthly total returns from January 1999 through June 2002 are 99.4% correlated, largely from sharing many of the same components. On June 30, 2002, the Fortune 500 shared 331 components with the S&P 500. It also contained 120 components not in the S&P 500, and the S&P contained 169 not in the Fortune 500, suggesting that differences in their composition affect certain performance characteristics, especially revenues and market capitalization.

Their contrasting composition is dramatically illustrated by comparing the operating revenues of the components exclusive to each index. The total revenues of the 120 exclusive Fortune 500 components were $780.1 billion, and their market cap was $417.6 billion on June 30, 2002. They had $1.87 worth of revenues for every $1 of market cap. In sharp contrast, the total revenues of the 169 companies exclusive to the S&P 500 were $653.9 billion with a market cap of $1.076 trillion. They had $0.61 of revenues per $1 of market cap, or only about one-third the value of the corresponding Fortune group.

Figure 1 shows the revenues and market capitalization of each of the 20 smallest components unique to each index. Clearly, even the smallest exclusive components of the Fortune 500 have greater revenues relative to their market cap than the S&P 500's. In fact, the ratio of revenues to market cap is $7.06 to $1 for the Fortune 500's 20 smallest components versus $1.62 to $1 for S&P's. The Fortune 500, therefore, is more clearly tilted toward revenues and the S&P 500 toward market cap. This suggests that larger-cap stocks in the S&P 500 index are possibly more vulnerable to downside corrections than those in the Fortune 500 because they may not have adequate revenues to support their valuations.

Sector Diversification

Despite the high correlation between the monthly total returns of the Fortune 500 and S&P 500 indexes, differences in their constituents give them different sector exposures. These differences are illustrated in Figure 2.

At December 31, 2001, the Fortune 500 had greater exposure to sectors that are traditionally considered more stable: consumer discretionary (15.5%), consumer staples (8.6%), financials (18.7%) and utilities (3.5%). The S&P 500 index, on the other hand, was more concentrated in sectors regarded as more volatile: energy (6.3%), industrials (11.3%), information technology (17.6%) and materials (2.6%). More recently, S&P's market-cap weight in information technology decreased to 13.9%, but the S&P 500 still contains 77 components in this sector. The Fortune 500 has fewer than half that number, with 37 information technology components accounting for 8.2% of the index's market cap. In sum, S&P's selection process appears to favor sectors having greater volatility, while Fortune's process seems to favor those with lower volatility and without a large amount of turnover in components or a change in which sectors are traditionally more volatile. This difference will probably continue.

Market Capitalization

There are also differences between these indexes with respect to their market capitalization. The largest stock in both the S&P and Fortune 500-General Electric-had a market cap of $397.9 billion on December 31, 2001. The stock with the smallest cap, $431 million, is more than twice the Fortune 500's smallest stock with a capitalization of $208 million. There is also a significant difference in their median size, $8.3 billion for the S&P 500's median stock versus $7.7 billion for Fortune's. Fortune's average company had a market cap of $22.5 billion, $1.6 billion greater than S&P's $20.9 billion.

Performance Characteristics

Monthly total return data are available since the beginning of 1999 for the Fortune 500 and back to the beginning of 1926 for the S&P 500. Accordingly, we compared the monthly total return series for both indexes from January 1999 through June 2002. Both series are highly correlated throughout the time period with a correlation coefficient of 99.4%. Figure 3 compares their annual returns and standard deviations.

The Fortune 500 outperformed the S&P 500 in 2000, 2001 and 2002 (through June), all in declining markets. It underperformed in 1999, the first year of its inception, in a rising market. Although the comparison period is short, the Fortune 500's superior returns in recent years suggests that it has different performance characteristics than the S&P 500.

The historic volatility of the two indexes further illustrates differences in their performance. The Fortune 500 has had less volatility, as measured by annualized standard deviation of total returns, than the S&P 500 in the latest three periods analyzed, and its volatility coincided with the S&P's in 1999.

Despite the limited period over which the analysis was conducted, the evidence suggests that the Fortune 500 has a higher return and less volatility than the S&P 500, implying that the former is a more suitable alternative as a benchmark for U.S. large-cap blue-chip stocks. To shed further light on this issue, we compared the performance of the Fortune 500 against the S&P 500 over the last 10 1/2 years. (Historical index values for periods prior to April 30, 1999, were calculated by Ibbotson Associates.)

Historical Analysis

Monthly price changes of the Fortune 500 and S&P 500 were computed for the period from January 1992 through June 2002, and the two series are 99% correlated. A comparison of their annual price appreciation appears in the table in Figure 4.

During the period, the Fortune 500 achieved greater price appreciation in eight of the nearly 11 periods and an average annual increase of 9.5% versus the S&P 500's 8.6%. The Fortune 500 outperformed the S&P 500 between 1994 and 1998 and from 2000 on, in both rising and falling markets. The length of the period seems sufficient to conclude that the Fortune 500 would have provided investors with greater price appreciation than the S&P 500.

The historic volatility of the Fortune 500 and the S&P 500 further illustrates differences in their performance. As shown in Figure 4, the Fortune 500 has less volatility, as measured by annualized standard deviation, than the S&P 500 in six years and equivalent standard deviation in three years, with an average of 13.8% versus the S&P's 14.1%.

In fact, the Fortune 500 outperformed the S&P 500 over interim periods over the last 10 years ended in June 2002, as shown in Figure 5, including year-to-date, 1-, 3-, 5- and 10-year periods based on price appreciation and volatility.

Summary And Conclusions

Does the Fortune 500 or the S&P 500 offer a better alternative for measuring the performance of high-quality, less volatile U.S. large cap blue-chip stocks? Our efforts show that the Fortune 500 has been the superior benchmark for U.S. large-cap blue-chip stocks since its inception in 1999. It has a higher return and lower volatility, while providing a diverse universe of blue-chip components. Also, the S&P 500 appears to have a subjective bias toward companies having more volatile earnings and market capitalization, which possibly leads to its greater market volatility relative to the Fortune 500.

We also reviewed the back-casted, historical performance of the Fortune 500 during the 10 1/2-year period ending in June 2002 and compared it with the S&P 500's performance. We found the Fortune 500's annual price appreciation outperformed the S&P 500's, and with less volatility, for most of the period. Therefore, we conclude that the Fortune 500 is a superior proxy for large-company U.S. stocks than the S&P 500 Index. We attribute the superior performance to the selection process used to determine the Fortune 500.

C. Michael Carty is founder of New Millennium Advisors, an investment management firm in New York City. Herbert D. Blank is president of QED International Associates, an investment consulting firm in New York City.