S&P 500: An Active Management Closet Case

There is a debate raging in the investment industry about the merit of fundamentally-weighted indices versus the traditional approach to indexing which uses a market cap-weighted schema. The argument centers on the academic question of how efficient markets are, and whether or not it is possible to “build a better mousetrap” by doing something other than taking a passive, market-cap weighted approach to building an index. But the one thing that almost never gets mentioned in this debate is that the penultimate poster child for passive indexing, the S&P 500 (SPY), has all the hallmarks of an actively managed, subjective portfolio.

The S&P 500 consists of five hundred large cap stocks representing roughly 80% of the overall market for publicly-traded U.S. equities. However, the index does not simply consist of the largest 500 companies by market cap. Rather, stocks are selected for inclusion by the S&P Index Committee, whose judgments about which stocks to add and which to exclude constitute de facto active management just as if the committee was a portfolio manager at your average fund company.

The S&P 500 Index Committee maintains guidelines on index membership criteria which go beyond passive observance of market cap levels. Among other things, these guidelines include profitability requirements (i.e., a company actually has to have profits) and “seasoning,” a minimum amount of time in existence as a publicly traded corporation. Collectively, these rules impart a character on the index akin to an investment philosophy that, whatever its merits, is different than if the selection criteria were purely market driven. But what bears even more traits of active management is the fact that these are only guidelines which the S&P Index Committee can and often does disregard.

For example, during the 1990s index turnover soared, from 7 stocks in 1992 to 57 stocks in 2000. One tech stock after another was added to the index, and several that met neither the profitability requirements nor the seasoning requirements were added only to be removed a short while later when their market values collapsed. More recently, during one of the greatest real estate booms (bubbles?) in American history, the committee reversed its longstanding prohibition against the inclusion of holding companies, and started adding Real Estate Investment Trusts (REITs) to the index in late 2001, where they have grown in number to fourteen.

This is all reminiscent of the kind of “style drift” for which active mutual fund managers are often derided. Evidence of this tendency in the S&P 500 can be seen by measuring changes in the index’s divisor . It is typical for the divisor to rise a percentage point or two over the course of the year, as new entrants often rank around the middle of the S&P 500 while those that “fall out” often rank towards the bottom of the index in terms of size.

However in the late 1990s this relationship fell apart. Whether conscious or unconscious, the S&P Index Committee skewed the S&P 500 heavily in favor of mega-cap growth stocks, often Tech-related, in turn causing the index divisor to soar to more than four times average (Figure 1). We now know of course that this shift in favor of mega-cap Tech stocks turned out to be a bad call, but the bottom line is that it was, in fact, a judgment call. In other words, active management.

Figure 1: Change in S&P 500 Divisor, YoY

So what does all this mean for investors? I think it means that while the academic debate about market efficiency will continue to rage, you shouldn’t limit yourself to funds that mimic the S&P 500 or are benchmarked to it, because the S&P 500 is itself a creation of the changing emotions and judgment of a small group of people who have no better information than any other market participant.

In short, the S&P 500 may be market-cap weighted but it by no means represents “the market.” Rather it is a subjective subset thereof. So unless you’re going to buy a total market index fund and be done with it, there are other strategies worthy of consideration, especially the array of fundamentally-weighted index ETFs cropping up, such as the PowerShares FTSE-RAFI 1000 (PRF).