The Curse Of Indexing Can Be Turned Into A Buying Opportunity

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Includes: RSP
by: Vincent Deluard, CFA

On October 24, Xylem (NYSE:XYL) made its entry into the S&P 500 index, replacing ITT Corp (NYSE:ITT), which was downgraded to the S&P Midcap 400. Companies are usually extremely happy to join a major stock index. Being a Dow Jones Industrial Average Member or a S&P 500 member brings plenty of analyst coverage and respectability. It also brings the natural demand of index funds which need to acquire the newcomer.

But should investors in index funds rejoice? My study of the performance of recent additions to the S&P 500 shows that new additions tend to be horrible investments.

Since the beginning of 2008, I counted 42 additions to the index and 40 deletions. Tracking the performance of deleted stocks is often impossible because many get delisted following takeovers, so I focused only on the performance of the additions. I measured the total return of the additions from the close of the day of their introduction in the S&P 500 index. I compared them to the performance of RSP (Rydex S&P Equal Weight ETF) over the same period. Using the equal-weight ETF allows us not to worry about differences in market capitalization. Note that this is a rather generous benchmark for Standard & Poor’s since the returns of RSP are amputated by its management fee of about 0.4% annually.

Additions to the S&P 500 index returned a miserable 17.3%, against a gain 34.3% for RSP on average. Only 14 of the 42 newcomers outperformed RSP. Worse, the performance of the new picks was boosted by the (lucky) addition of Priceline (PCLN) on November 3, 2009: the online auction service soared 216% since that date.

Remove this pick and the average performance of the additions falls to 12.4%, underperforming RSP by 21 percentage points. No portfolio manager would retain their jobs with such a lousy performance. More embarrassingly, this anomaly is persistent and well-documented in academic literature. Added companies tend to soar in advance of the addition date only to underperform in the following months. Conversely, deleted companies initially drop but often outperform in the following months.

Psychological factors and market forces explain the anomaly. Stocks that get added to the index will, of course, experience a surge in demand from index funds on the day of their inclusion in the S&P 500 index. Anticipating this, many fund managers purchase the likeliest candidates well in advance of the changes in the index composition, leading most index additions be fully valued even before they officially join the index.

By contrast, any stock deleted from the index but still a going concern becomes abandoned by both the index funds as well as the funds who tend to mimic the benchmark’s changes; the so-called “closet index funds.“ Such forced selling can often create bargains since such deletions often reflect a past history of poor performance, leading Standard & Poor’s index committee to finally conclude that the lagging company “is no longer representative of the U.S. economy.”

The inherent flaw of market-cap weighting is also at play: by definition, additions are companies whose relative market capitalization has risen, swollen either through the issuance of new shares or through strong relative performance. Either way, they tend to be yesterday’s winners. The addition of Netflix (NASDAQ:NFLX) on December 17 2010 is a cautionary tale of the index’s bias towards aging investment fads: the stock has plummeted by about 55% since it joined the index. Piling into overbought stocks is rarely a winning strategy.

What should investors do to beat the curse of indexing?

  • Day traders could try to game the system, by buying stocks that are likely to get added to the S&P 500 long before any changes and selling them immediately after their addition.
  • Buy-and-hold investors should carefully monitor deletions from the index: has the stock been delisted because it is no longer profitable (one criterion used by the index committee) or simply because of its poor performance? Has it plunged in the weeks prior to its deletion? If so, the curse of indexing can be turned into a buying opportunity. Investors should be especially on the watch for companies that get delisted for no other reason than that they no longer represent the US economy in the eyes of the S&P index committee. The S&P index committee does not attempt to maximize returns when it rebalances the index: it simply tries “to reflect the U.S. equity market, and, through the markets, the U.S. economy.” As a result, the S&P 500 is a mirror of our collective fads and mistakes.
  • Passive investors should abandon the religion of market-cap weighting. Investing in market-capitalization-weighted index fund is just one approach to equity investment. As any other strategy, it has flaws and will not work all the time. Investors would be well-advised to complement their market-cap weighted index funds with equally-weighted or fundamentally weighted funds.

The passive indexing revolution brought many benefits to retail investors by making them avoid expansive and poorly-performing active mutual funds. But index funds have become victims of their success. The mechanism of indexing, which is designed to passively track its components, can create changes in the prices of its components which have nothing to do with value.

Click to enlarge

2011 Changes to the S&P 500 Index

Change Date

Addition

Deletion

Addition Return

RSP Return

SPY Return

23-Sep-11

MOS

NSM

7.1%

14.8%

13.3%

5-Jul-11

ACN

MI

0.2%

-6.0%

-3.4%

30-Jun-11

MPC

RSH

-9.3%

-4.7%

-2.0%

2-Jun-11

PLD

-12.1%

-4.1%

-1.4%

1-Jun-11

ANR

MEE

-53.7%

-4.2%

-1.5%

27-Apr-11

CMG

NOVL

30.6%

-6.5%

-4.2%

1-Apr-11

BLK

GENZ

-15.9%

-4.6%

-2.4%

31-Mar-11

EW

Q

-13.3%

-4.1%

-2.0%

28-Feb-11

COV

MFE

4.6%

1.6%

2.4%

25-Feb-11

JOYG

AYE

-6.7%

-3.3%

-2.0%

11-Jan-11

NE

QLGC

-1.6%

-2.9%

-1.4%

3-Jan-11

MMI

MDP

29.0%

1.7%

2.7%

Note: All data as of Oct 28, 2011. Includes reinvested dividends.

Disclosure: I have no positions in any stocks mentioned, and no plans to initiate any positions within the next 72 hours.