In the weeks following the Sept. 11 terror attacks and the federal halt to all air travel, the committee that controls the Standard & Poor's 500 index considered expelling all airline companies from the key market benchmark. The idea, says David M. Blitzer, chief investment strategist at S&P and head of the panel, stemmed from a fear that the airlines suddenly starved of income were headed for bankruptcy.

S&P ultimately opted not to shove airline stocks off the U.S. market's main runway, in part to avoid the appearance of panic. But the mere fact that the notion was entertained reveals how the index, indirectly the world's most widely held equity instrument, is managed as much by the personal beliefs of market participants, just like any managed fund, as by its strict published guidelines.

"At the end of September, I could have taken out every airline, but we made a conscious decision to ride them out because they represent an important part of the market," Blitzer said in an interview last week at the company's New York headquarters.

Blitzer's words were both reassuring and eerie. Reassuring because it confirmed my view that the index is far from the scientific measure of the largest U.S. stocks that most private investors believe it to be. Eerie because it also underscores the mixture of noblesse oblige and capriciousness that underlies judgments that influence $1 trillion in index-replicating funds such as the ( VFINX) Vanguard 500 Index .

The S&P committee's methodology may seem like an arcane field of study, but it is critical to probe at a time when the index faces its third straight year of double-digit losses. Many investors in the 1990s came to consider an investment in the S&P 500 as a cheap, smart, risk-free way to participate in the great American stock bonanza. Financial advisers and the academic community sold them on the notion it had a "passive" management style that provided insulation from harm.

In three prior columns, I have described how specific decisions in 1999 and 2000 led the once-sleepy index down a reckless path that exacerbated investor losses. But an interview last week offered my first chance to understand the index chief's state of mind more clearly. In a wide-ranging discussion, Blitzer revealed that the costly implosions of index inhabitants Global Crossing, Enron and Kmart in 2001 have led him to be at least as concerned with risk-control as about the task of mirroring the phantasm called "the market."

Management by Gut

Consider the expulsion of WorldCom Group on May 13, when it still had a market capitalization of about $3.8 billion and a stock price around $1.60. The one-time telecom giant's $30 billion in debt had just been downgraded to junk status. But no fraud had yet been uncovered, and many believed it could survive without filing for bankruptcy protection. So why did Blitzer -- who interchangeably uses "I" and "we" when referring to the committee's actions -- kick it out?

"It was a gut feel that we had," he said. "We didn't see any way that it could come out of its difficulties. Plus, there was the risk that something else could come along to kill the stock. The way it was trading, it did not seem like anyone was waiting in the wings to inject capital, buy it or somehow save it."

It turned out that Blitzer and his team were right, as WorldCom declared bankruptcy a short time later. But "gut feel" isn't the methodology that most investors believe is at the root of purportedly passive index decisions at Standard & Poor's. Prior rules of engagement, listed on the organization's Web site, state that companies headed for the rocks are to be removed from the index "immediately after Chapter 11 filing."

Last week's removal of handheld-computer manufacturer Palm ( PALM) offers another example of the new era. Many Wall Street old-timers were originally appalled in July 2000 when S&P put the unseasoned company into the index after it was spun out of networking equipment maker 3Com. Skeptics complained that the move, in which Palm replaced its parent in the S&P 500 and 3Com sank to the S&P Midcap 400 index, violated a rule requiring candidates to have recorded at least four consecutive quarters of positive earnings.

The fullness of time has proved the back-benchers right. Palm went on to decline 95% from July 2000 through August 2002, to a current market capitalization around $600 million, while 3Com only declined 65% to a current market capitalization around $1.7 billion. The bad call probably hacked less than one-half a percentage point off the S&P 500's 37% return over that period, but every little bit counts.

Now, fast-forward to last week. Why did the committee slap Palm clear out of its index system, without even a demotion to the S&P SmallCap 600? Blitzer grinned before answering that people who ask that question fall into two "caricatures." Investors who want better performance ask, "Why did you wait so long?" Meanwhile, passivity purists ask, "Why are you managing the index?"

Blitzer said the committee has a "private, quiet" list of S&P 500 companies, such as Palm -- and formerly Conseco and US Airways -- whose business viability is in doubt. He said the committee frets that if it removes them too hastily and they ultimately rebound from $1.19 to $5, observers in the first camp will cry, "You're an idiot!" In its meetings, he said, the committee debates whether each hammered company in the big index -- and there are 19 priced under $5 that are down 70%-plus this year -- is "in its death throes, or will it go back up?" The very real, widespread threat of bankruptcy is now the overlay for all decision-making on the removal of index constituents.

Passivity Isn't Key to Past Performance

In other words, the committee increasingly acts just like any fund management team, relying in part on a set of guidelines (listed below), but also on their own hopes and regrets. Rather than being governed by an all-knowing and unflappable Oz, the list of stocks responsible for the retirement and college-education fates of millions is guided by an affable, gray-bearded, bow-tied economist whose curtain has become increasingly transparent.

Blitzer and his team reflect the market. Not in the way that academics see it, as a steady beacon of market efficiency, but rather in its emotional mood swings. The fact that the performance of the S&P 500 over time matches that of the Russell 1000 and Wilshire 5000, which are truly mechanically passive indexes (though flawed in their own way), is only reflective of the fact that its 500 securities comprise more than 75% of the capitalization of the U.S. market. The next 500, or 4,500, just add color around the edges. Even the biggest stock ever added, which was MSN Money publisher Microsoft ( MSFT), amounted to only 1% of the capitalization of the index. Ryan Carrier, director of global business development at S&P, put it succinctly: "If you own 500 big stocks, it's hard to stray too far from the market."

The lesson is that while index-based funds such as the Vanguard 500 were successful in a bull market, they beat peers not because of some ideal of passivity but because they were inexpensive, highly liquid pure plays on a popular concept enjoying its extended 15 minutes of fame. Blitzer himself noted that the investment mood of the late 1990s, like the early 1970s, "played to our style" of representing big-cap growth companies. He added that investors would have made a lot of money with the style "as long as they did not stay too long." Carrier added that he believes most underperformance from large-cap equity funds came about not because of their active management styles, but because of "cash drag," or the fact that non-index funds are seldom fully invested at the time of large upside moves in the broad market during bull runs.

As a result, Blitzer said he doesn't feel any sorrow that S&P 500 index investing isn't working as a style now, since he doesn't overtly shape it for success. "When the market goes down, the index should go down!" he exclaimed. "I would love for it to go up when the market goes down, but I don't get that thrill."

We don't get it, either. Private investors who continue to apportion the bulk of their assets to big-cap index funds should consider alternatives even though their losses already are great. Institutional managers are virtually forced into the index vehicles because of their need for what the industry calls prompt "cash equitization," or the transmogrification of 401(k) dollars each month into stocks as quickly as possible. But individuals have more intelligent choices for active management, including funds such as ( ARGFX) Ariel , ( MPGFX) Mairs & Power Growth , ( DODGX) Dodge & Cox Stock and ( CFIMX) Clipper .

Fine Print

To learn more about S&P's guidelines for the addition and removal of stocks from the 500 index, visit this page . Basically, stocks must have logged four consecutive quarters of earnings, trade in high volume, have a minimum market capitalization of about $3 billion, be domiciled in the U.S. and be representative of their economic sector. After 2 1/2 years of market decline, very few qualifying U.S. companies with market caps greater than $4 billion are not on the list. A couple likely to be added this year are Laboratory Corp. of America ( LH), Kraft Foods ( KFT), Genentech ( DNA) and DST Systems ( DST).

To check for S&P 500 index changes, visit this page after market close from time to time. Although given the occasional boost a newly added company gets thanks to the "S&P Effect" -- when funds that try to ape the index have to buy up shares -- you may hear about the changes in the news first.

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