Just about every investor dreams about beating the S&P 500. But - especially lately - not everyone can.
|What Is The S&P 500?
The Standard & Poor's 500 Composite Stock Price Index (S&P 500) is a benchmark, or measuring stick, for U.S. stock market performance. It is made up of a mix of 500 U.S. companies that are leaders within their sectors, but are not necessarily the largest companies in the United States.
The index's value is calculated by adding the market values of the 500 stocks and dividing the total by a number called the "index divisor," which makes it possible to compare index values over time.
The S&P 500 is managed by an objective Index Committee at Standard & Poor's. The committee's analysts are responsible for making sure the companies in the S&P 500 meet specific, detailed criteria relating to market capitalization, market sector, and other factors. They keep a list of qualifying companies in an Index Replacement Pool. If a company is removed from the S&P 500 because of a change in its status (merger, acquisition or bankruptcy, for example) the committee chooses a company from the pool to replace it. The chosen company hears about its new status at the same time as the general public does.
Generally, the index sees only a few changes each year. Being added to the index can cause a company's stock price to rise, and being removed can provoke a fall, since many index funds tend to buy what is in the S&P 500 and sell what is out.
If you have mutual funds that are invested in large US stocks, and they have been underperforming the S&P 500 lately, don't despair. It can be discouraging to own a stock fund that doesn't do as well as what most consider to represent "the market." But there are some good reasons why the index has been so difficult to beat lately. Read on, and you'll find out what they are… and also learn why you can't always compare your mutual fund's performance to that of an index.
Construction of the index
The S&P 500 is a market-weighted index, as opposed to an equal-weighted or price-weighted index like the Dow Jones Industrial Average. This means that the S&P 500 gives each stock a "weight" that is in proportion to the market value of the company. For example, Microsoft recently surpassed GE as the largest company in the U.S., so it has also passed GE to score the largest weighting in the S&P 500 (at nearly 3.5%). Since there are 500 stocks in the index, its overall movement will be influenced more heavily by price changes in the stocks with the heaviest weightings (and largest market capitalization).
In the Dow Jones Industrial Average, by contrast, the 30 stocks comprising the index are weighted according to price. The higher the price, the heavier the stock's "weight".
If you measure the performance of your mutual fund's manager against a market-weighted index such as the S&P 500, you may not be comparing apples with apples. Here's why:
Microsoft constitutes nearly 3.5% of the S&P 500 index, while Nordstrom comprises .05%, meaning that Microsoft's impact on the performance of the index is 70 times Nordstrom's. There are over 150 stocks in the index with even less weight than Nordstrom. In fact, the top 20 stocks in the S&P 500 represent nearly one-third of its value, and the top 100 stocks, one-fifth of the total, represent three-quarters of the value. Four of the top 10 holdings - Microsoft, Intel, Cisco and IBM - alone make up over 8% of the value of the index, a substantial portion considering the total number of stocks in it.
The message is clear. Although the index appears at first glance to be a well-balanced basket of 500 stocks, in reality, because of the weightings, it is much more narrowly focused on the biggest companies. Therefore, when the top stocks in the S&P 500 do exceptionally well, it is difficult for a well-diversified mutual fund to outperform it by a substantial margin, or at all.
Following are the stocks that have fueled the index in 1998 and their contribution to the overall performance of the S&P 500, which rose 28.6% in 1998:
||% of S&P gain
|Source: Barron's, Deutsche Bank Securities, Morningstar Principia Pro
As long as active money managers use valuation constraints that limit the stocks they are willing to buy (in other words, they do not buy stocks they consider to be overpriced), their performance will diverge from the index. Unfortunately, divergence has not been a good thing over the last five years, when the S&P 500 has increased more than 24% on an annualized basis. However, divergence can be good when the general trend of the S&P 500 is downward.
Proliferation of Index Funds
Indexing, or passive management, has become increasingly popular over the last five years. The popularity of, and surge of assets into, Vanguard's flagship Index 500 fund is a testament to the fact that many investors have embraced the concept of "passive investing". The fund has grown from $9.3 billion in assets in 1994 to over $70 billion today!
A myriad of retail and institutional index products have flooded the market over the past few years, which has had several related effects:
- More index funds means more demand, driving up the prices of the underlying stocks.
- The higher a stock's price is driven, the bigger its market cap becomes.
- As a stock's market cap becomes larger, index funds must buy more of it in order to mirror the index.
Note that this is all made possible by the current bull market, which in turn is due to solid economic growth, low inflation and a low interest rate environment - there couldn't be a more perfect environment for stocks, particularly large, growth-oriented stocks. If and when economic or company fundamentals turn unfavorable, the large, blue-chip, high-multiple growth stocks will return to more "normal" valuation levels. This will mean a decline in stock prices - in some cases a substantial decline. As stocks in the index decline in price, index funds will sell those stocks, causing prices to decline further, etc., etc….
Given the scalding hot performance of passively managed index funds, some active managers have realized that in order to match or beat an index, they must buy the stocks that are going to have the most impact on the index. This is commonly referred to as "closet indexing". This creates a demand that further props up the prices of … (you guessed it) the largest of the large stocks.
A variation of this strategy is called "enhanced indexing". This occurs when a fund manager tries to derive most of the returns from the index while also attempting to add value by either over- or underweighting particular stocks and/or sectors, based on fundamental or technical reasons. Again, this means buying more of the stocks with the largest market caps - Microsoft, GE, Coca-Cola, Merck, to name a few. More buying means higher prices, etc…. You get the picture.
Expenses, Fees, Transaction costs
Another advantage that can make index funds look more attractive than actively managed funds is their substantially lower expenses and transaction costs. Index funds simply do not have significant costs associated with managing them. All else being equal, the performance of an index will always be higher than that of a fund buying the same stocks and levying a management fee, 12b-1 fees and incurred trading costs. These costs and fees are taken from the total fund assets, which directly reduces the return to investors.
Overall expenses generally average between 0.8 % and 1.5% for actively managed funds and are levied every year, regardless of how the fund does. Some managers are worth the fees and expenses; some are not. Note that when comparing a fund to an index, the index will always have this distinct advantage.
The reason it has been so hard to beat the S&P 500 lately has a lot to do with economic cycles and how the index is weighted. The index does extremely well when large companies do well, and suffers when the largest companies do poorly. As of late, the large companies have performed exceptionally well and the index has performed remarkably. Perhaps when (not if) the larger-cap, blue chip growth stocks fall out of favor, the S&P 500 will be easier to beat. We'll see!