One myth that appears to be imploding along with the market is the notion that investors should "passively" buy the market via the

S&P 500

index rather than buying individual stocks.

It's not just that the S&P 500 is down a bunch this year or last. It's that the index has done so poorly relative to other key benchmarks for reasons that look suspiciously like pilot error: The index is down 34% since the start of 2000 through June 25, 2002, more than 50% worse than the decline of its archrival, the

Dow Jones Industrial Average

, largely because of a series of reckless decisions to add high-momentum technology stocks in that pivotal year.

Of the 45 stocks that Standard & Poor's added to its benchmark index in 2000 that remain in the index, 22 are down more than 50%. Thirteen of those are down more than 75%, and eight are down more than 85%.

If a major institutional money manager had posted a record like that, he would have been run out of town. Yet for some reason, Standard & Poor's has managed so far to skate clear of its measure of blame for the ruin of millions of retirement accounts entrusted to its care in the form of mutual funds and pension funds fated to shadow its wrong-way run. Why?

The S&P 500 Is Not Passive at All

This is not a trivial matter. By some estimates, nearly three-quarters of a trillion dollars are managed worldwide in sync with the S&P 500 -- making it without doubt one of the most widely held financial instruments on the planet short of U.S. Treasuries. The granddaddy of public funds in the category is also the nation's largest fund -- the

(VFINX) - Get Vanguard 500 Index Inv Report

Vanguard 500 Index with $74 billion in assets. Investors in these funds have lost almost 9% annually in the past three years, at a time when holders of more professionally managed funds owning a similar blend of large growth and value stocks, such as the

(DODGX) - Get Dodge & Cox Stock Fund Report

Dodge & Cox Stock Fund, have gained as much as 7.3% annually.

One reason that S&P, a division of

McGraw-Hill

, has not come under fire for the index's poor performance is that most investors seem to think it is a quasi-scientific measure that depends on little or no human intervention. The truth is an eight-person committee of S&P bureaucrats -- editors, business managers, quantitative analysts and an economist -- wields a heavy hand in its purportedly passive management. There are no professionally trained or regulated money managers on the team, according to Elliott Shurgin, vice president for index services at S&P.

Defenders point out that the Russell 3000, a measure of the market's largest 3,000 stocks, has done about the same as the S&P 500. Yet, as risks of the S&P orthodoxy have become more apparent, a few voices in the industry have emerged to speak against it. Alan Newman, an analyst at brokerage HD Brous in New York, said in an interview that he believes Vanguard, among others, "has done a very great disservice by advancing the thesis that instead of trying to beat the market you should buy the market. The problem is that the S&P 500 isn't the market -- it's an actively managed fund, and a poorly managed one at that."

This is not just a question of one company picking better stocks than the other. It's a question of a flawed design that rewards sector momentum over common sense. Unlike most index publishers, such as the

Nasdaq

and Dow Jones, Standard & Poor's adds and subtracts stocks from its three broad indices -- the large-cap 500, the MidCap 400 and the SmallCap 600 -- frequently in accordance with a largely subjective list of criteria that includes market capitalization, liquidity and S&P's representation of industrial sectors.

It's this last criteria that got S&P into trouble in 2000 as it tried to keep pace with the explosive 1999 performance of the tech-heavy Nasdaq 100. Every month a number-cruncher at S&P adds up the total capitalization of all 9,000 or so stocks traded on U.S. exchanges, and determines the percentage representation of each broad industrial sector, such as technology, health care and capital goods.

After technology stocks roared into favor in the late 1990s, S&P found that the market had given an 18% weighting to tech stocks while its index had only a 14% weighting. So the committee considered itself obligated to raise its weighting in tech stocks in short order. As a result, not only did S&P 500 index managers yank out the stocks of seemingly stodgy retailers and industrials to add shares of technology companies such as

JDS Uniphase

(JDSU)

,

Veritas Software

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and

Broadcom

undefined

near their historic highs in 2000, but because these decisions don't have a rip cord, they then proceeded to hold them while many plunged 80%-plus.

The committee did the same with new-age electric power producers

Dynegy

(DYN)

and

Calpine

(CPN)

; biotechs

MedImmune

(MEDI)

and

Biogen

undefined

, and business services provider

Convergys

(CVG)

.

In all, the stocks added by S&P to its index in 2000 are collectively down about 43% on average through June 25. (See my

Dec. 21, 2001 column, which reported that expelled stocks have generally performed better than added stocks in the past three years.)

Shurgin said his team's mandate is "to reflect market weights in the indices -- that's the beginning, middle and end of the discussion. We are followers, not leaders." But that has proved to be an elusive and expensive theory, and S&P is now in the fight of its life to undo the damage before its index sinks into irrelevance and drags its lucrative licensing fees down with it. In the past ten months, S&P has already removed three members of its ill-fated class of 2000 for what it calls "lack of representation":

BroadVision

(BVSN) - Get BroadVision, Inc. Report

,

Sapient

(SAPE)

and

Global Crossing

undefined

. And last week it announced plans to remove a fourth,

Conexant Systems

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.

Only a miracle rebound in the Nasdaq's fortunes will likely prevent S&P from removing from the large-cap 500 at least two other companies that would not even qualify now for the MidCap 400 --

Vitesse Semiconductor

(VTSS)

and

Power-One

(PWER)

-- as well as the much larger but equally damaged JDS Uniphase and

Applied Micro Circuits

(AMCC)

.

Three technology stocks added in the class of 2001 that appear doomed for removal this year because of their shrunken market caps and prices under $5 are

Palm

(PALM)

,

TheStreet Recommends

Ciena

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and

PMC-Sierra

(PMCS)

.

And names added in prior years that seem equally unrepresentative of anything but debt or dishonor are

Nextel Communications

(NXTL)

,

Corning

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,

Nortel

(NT)

,

Qwest

(Q)

and

Parametric Technology

(PMTC)

.

More pessimistic observers would also add

Gateway

(GTW)

,

ADC Telecommunications

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and

Lucent

(LU)

, as well as nontechs

Conseco

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and

AES

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. All are trading at prices under $5 and have fallen 55% or more in the past year.

Said Newman: "The end game is that there was a move over several years toward index funds, and now we'll have a move away from them as people become distressed to learn that their so-called passive investment vehicles were actively managed by drivers who didn't know how to hit the brakes on stocks down 80%-90%."

QQQ Investors Stuck With Bad Stocks

Kenneth Safian, chief executive of Safian Investment Research in New York, says he thinks the problem arose because the S&P 500 and Nasdaq 100 are not true indices measuring the U.S. economy or the strength of an investment philosophy, but rather are the products of marketing organizations with something to sell.

"These indexes don't represent anything but some manager's hopes and dreams," he said.

Indeed, the irony for S&P is that since January 2000, the Nasdaq 100 has doubled the misery of the S&P by sinking 73%. Before explaining why this matters, first endure a little background.

The Nasdaq 100 was developed in 1985 to track the performance of the 100 largest nonfinancial companies traded on the exchange, said John L. Jacobs, chief executive at Nasdaq Financial Services. (There was already a Nasdaq Financial 100 Index to track large banking companies trading on the exchange.) Fourteen years later, the organization created a unit investment trust based on the index that trades under the symbol QQQ.

The vehicle launched with an initial deposit of $14.9 million in March 1999 and quickly swelled with the ballooning interest in the many tech stocks traded on Nasdaq. Assets reached $6 billion by the end of that year and $22 billion by the end of 2000. That amount has not changed in the past two years, though Jacobs estimates that at least another $8 billion in institutional money worldwide directly or indirectly tracks the Nasdaq 100, bringing assets focused on the index to a whopping $30 billion.

Unlike Standard & Poor's, Nasdaq rebalances its leading index according to strict statistical criteria once a year, on the third Friday of December. Essentially, all 5,000 or so Nasdaq stocks are ranked from high to low by market capitalization, and the largest 100 that have been public for at least two years and trade at least 100,000 shares daily make the index. If an index stock falls to rank 101st to 150th in market capitalization at the time of the rebalancing, it is given a one-year grace period before facing expulsion. If it falls below the 150th rank in any year or fails to regain the 100th spot or better in its grace-period year, the stock is expelled and replaced by the next-highest ranked Nasdaq member. The only major exceptions are companies that are delisted from Nasdaq, as

Adelphia

was a few weeks ago.

This means QQQ investors are thus forced to own absolute dogs for as long as a year after their crimes against shareholder value become evident to even the dullest active manager. And in bear markets characterized by heavy sector rotation, it means that stocks added to the index are typically inserted into QQQ owners' portfolios at their historic highs just as their time to fade has arrived (the same is true for the Russell 3000).

In December 2001, Nasdaq expelled such under-$1 dot-com relics as

CMGI

(CMGI)

,

Metromedia Fiber Network

(MFNXQ)

,

McLeodUSA

(MCLD)

and

Inktomi

(INKT)

from the index only to replace them with 13 biotech and cable stocks that have gone on to repeat their elders' swoon.

The 13 new names in the Nasdaq 100 are collectively down 49% since inclusion on Dec. 21, 2001, which just about doubles the Nasdaq Composite's 25% collapse in the same period. Leaders of the catastrophe for passive Nasdaq investors, as shown in the table below, are mostly biotechs that benefited from hot money rotation last November and December:

ImClone Systems

(IMCL)

, down 86%;

Sepracor

(SEPR)

, down 83%;

Protein Design Labs

(PDLI) - Get PDL BioPharma, Inc. Report

, down 71%; and

Icos

(ICOS)

, down 70%.

Jacobs said his organization is studying the issue of the rebalancing of the index "very carefully" and could announce changes later this year. However, he insisted that he is not an asset manager and asked investors who have $30 billion in the pummeled strategy to note that current results are merely a reflection of the environment, and that over the past 16 years the Nasdaq 100 had rewarded patience with a 693% gain, vs. 497% for the Dow Jones Industrials and 369% for the S&P 500.

If you haven't got that kind of time left after losing 73% in the Nasdaq 100 since 2000, or 34% in the S&P 500, then perhaps now would be a good moment to complain loudly about your manager's historic collapse and consider alternatives.

At the time of publication, Jon Markman owned or controlled shares in none of the equities mentioned in this column.