Why the S&P 500 was not the best way to track the US market this year

An alternative index to gain exposure to US shares has outperformed the S&P 500 in 2020.

Overall, it has been a good year to be invested in US stocks. From the start of the year, the S&P 500 has returned investors 13.4% on a total return basis (priced in sterling), according to FE Analytics.

Double-digit returns in a year defined by a global pandemic and severe economic contractions are certainly impressive. Although as many readers will know, these returns were largely driven by a handful of tech giants, such as Amazon (NASDAQ:AMZN), Apple (NASDAQ:AAPL) and Microsoft (NASDAQ:MSFT).

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But was the S&P 500 the best way to gain exposure to the broad US market this year? The S&P 500 is now widely seen as the single best gauge of US large-cap indices, eclipsing the much smaller Dow Jones Industrial Average. Trillions of dollars are now benchmarked to the index.

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However, investors in 2020 would have been better off using a much less popular rival - the MSCI USA index. Since the start of the year, the index has returned 16.7%, giving investors returns roughly 3% higher. As a result, any index fund or ETF tracking the MSCI USA index will have provided a higher return than one tracking the S&P 500 index.  

Part of the reason for this difference in performance is the S&P 500’s stricter entry requirements. The S&P 500 requires a company to be profitable to be eligible for inclusion. At the same time, as of 2017, the index bans any companies that have dual class shares, which restrict the voting rights of shareholders. Finally, the S&P 500 has a committee that makes any final decisions about entry into the index.

In contrast, the MSCI USA index has fewer strict requirements. Also, unlike the S&P 500, the number of constituents is not bound by an arbitrary round number in its name. It currently has 618 stocks.

The S&P 500’s tighter rules arguably have investors’ best interests at heart. For example, a dual share class structure can result in poorer corporate governance, which can negatively impact the long-term performance of a company.

The problem in 2020, however, is that this has meant the exclusion of some of the best-performing companies of the year. For example, the dual share class ban means that the S&P 500 cannot include Zoom (NASDAQ:ZM), the video calling company that has returned more than 400% this year; Zillow (NASDAQ:Z), the online real estate platform, which has returned more than 200%; and social media company Pinterest (NYSE:PINS), which is up around 270%. All these companies, however, are in the MSCI USA index.

Meanwhile, the profitability requirement has meant that electric carmaker Tesla (NASDAQ:TSLA) has been excluded. That’s also created a drag on the index’s performance, with Tesla already up by around 600% since the start of the year. While the S&P 500 has announced that the company will be added to the index on 21 December, all the returns it has made this year have not benefited the index. Tesla, however, has been part of the MSCI USA index for several years.   

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Of course, the continued outperformance of the MSCI USA index compared to the S&P 500 is not guaranteed. Perhaps the poor corporate governance of dual share classes will negatively impact share prices over longer time periods.

In such a scenario, the stricter rules of the S&P 500 could be said to work in investors’ best interests. However, that’s not what investors necessarily look for indices to do – such thinking starts to look a bit like active management. 

As Vincent Deluard, director of global macro at the US financial services company StoneX Group notes, such requirements risk creating “a wedge between the actual stock market and what Standard & Poor’s index committee considers to be investable”.

However, from an investor’s perspective, there is potentially still one reason to stick with the S&P 500 for passive US exposure: fees.

ETFs tracking the S&P 500 tend to be much cheaper. For example, both theiShares Core S&P 500 ETF USD Acc GBP (LSE:CSP1) and the Vanguard S&P 500 UCITS ETF (LSE:VUSD) charge just 0.07%, which works out at £7 on a £10,000 investment.  

In contrast, both the iShares MSCI USA ETF USD Acc GBP (LSE:CU1) and the HSBC MSCI USA ETF GBP (LSE:HMUS) charge around 0.3%. 

That said, some ETF providers offer exposure to the MSCI USA index for highly competitive prices. The Xtrackers MSCI USA ETF 1C GBP (LSE:XDUS), for instance, charges just 0.07%, the same as Vanguard and BlackRock charge to track the S&P 500. Even cheaper is the synthetic Invesco MSCI USA ETF (LSE:MXUS), which charges just 0.05%.

Full performance can be found on the company or index summary page on the interactive investor website. Simply click on the company's or index name highlighted in the article.