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Abasic issue underlying financial theory is the constitution of the market portfolio. 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 and Scholes (1972), and Reinganum (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 Jensenâ€™s Alpha error of 2.04% associated with the wrong proxy for the market portfolio.

On the economic significance of the benchmark portfolio