S&P 500 Shows Passive Aggressive Side

There is a debate raging in the investment industry about the merits of fundamentally weighted indices vs. the traditional capitalization-weighted index approach.

A fundamentally weighted index's components are selected based on factors such as revenue, earnings and book value, while a capitalization-weighted index is based on the size of a company's market cap.

The argument centers on how efficient markets are and whether 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, appears to be an actively managed, subjective portfolio in disguise.

The S&P 500 consists of 500 large-cap stocks representing roughly 80% of the overall market for publicly traded U.S. equities. But 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 constitute de facto active management just as if the committee were a portfolio manager at your average fund company.

The S&P 500 Index Committee maintains guidelines on index membership criteria that go beyond passive observance of market-cap levels. After all, if it were a true market-cap index, there would be no need for a committee in the first place.

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.

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