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S&P 500 Shows Passive Aggressive Side

For a benchmark that is the very model of a market-cap index, the S&P sure acts like it's actively managed.

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.

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, turnover of the S&P's components soared in the 1990s. Only seven stocks were replaced in 1992, compared with 57 in 2000.

One tech stock after another was added to the index, and several met neither the profitability requirements nor the seasoning requirements. Of course, these stocks didn't last long on the index and were removed when their market values collapsed. More recently, the index has latched onto one of the greatest real estate booms in American history; the committee started adding real estate investment trusts to the index for the first time in late 2001. There are now 14 REITs in the index.

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.

The divisor keeps the index level stable during constituent changes. Since the S&P 500 is market-cap weighted, unless the replacement company was of exactly the same size as the company being deleted, the index level would change overnight were it not for adjustments to the 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 removed often rank at the bottom of the index in terms of size.

However, in the late 1990s, this relationship fell apart. Whether consciously or unconsciously, 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 its average (see chart below).

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.

Signs of Active Management
Changes in S&P 500 divisor go against the market-cap index principle

Source: Standard & Poor's

So what does all this mean for investors? It means that debate about market efficiency continues, so you shouldn't limit yourself to funds that mimic the S&P 500 or are benchmarked to it. That's 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 might be market-cap weighted, but it by no means represents the market; rather, it is a subjective subset of it. 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) - Get Free Report


Michael Krause is president and founder of AltaVista Independent Research. AltaVista provides fundamentally driven analysis of exchange-traded funds to help investors select ETFs based on investment merit, much the same way they would evaluate a single stock. The firm offers both print and online ETF research to subscribers, but does not manage clients' money. Mr. Krause is also a frequent contributor to broadcast and print media.