With S&P, You Get What You Pay For

Editor's Note: This is a bonus story from Jon D. Markman, whose commentary usually appears only on RealMoney . We're offering it today to TheStreet.com readers. This column appeared March 10 on RealMoney. To read Markman's commentary regularly, please click here for information about a free trial to RealMoney.


In your file labeled "Disingenuous Press Releases," please place the one published Wednesday by the equity index team at Standard & Poor's titled "75% of Non-Technology Issues Recover From Post-March 2000 Crash."

The purpose of the release, it seems, was to blame technology stocks for ruining the performance of the S&P 500 Index over the past five years. And yet it was not clearly disclosed that Standard & Poor's willfully and ruinously stuffed its flagship index full of technology stocks in that fateful year, much to the detriment of millions of investors.

How badly have the tech stocks of the S&P 500 done? According to the press release, only 11 of the 78 tech stocks in the benchmark index are higher today than March 24, 2000, the day the S&P 500 hit its all-time peak. In contrast, 304 of the 404 nontechnology stocks in the index are higher today. That is, 14% of tech stocks are higher, whereas 75% of the rest of the nontechs are higher.

The implication is that the S&P 500 -- on which more than $1 trillion in investment funds ride, due to the misguided indexing craze -- would be a lot higher, doggone it, if not for those pesky techs. Howard Silverblatt, equity analyst at S&P, notes in the release that tech stocks in the index would have to gain 209% from today to get back to 2000 prices. He adds: "On average, most issues within the S&P 500 have recovered. ... The enormous losses of high-cap technology issues have weighed down the market, resulting in a 20% loss."

So whose fault is that, exactly? You won't learn this from its release, but the raw truth is that S&P added two dozen technology stocks to its big-cap index in 2000 -- the most it has ever added in its long history. Most of these were put in the index not to replace companies that had been merged out of existence or were in danger of going bankrupt, but rather because index managers feared losing relevance to the then-soaring Nasdaq 100 (NDX).

The future differential between stocks removed from the index and the ones added in 2000 turned out to be dramatic, leaving observers to wonder how much wealth might have been retained by the public had S&P not blundered by stampeding into techs. Consider:

  • On June 2, 2000, S&P removed coal strip-miner and forklift-maker NACCO Industries (NC) from its big-cap index and replaced it with then-sexy Hewlett-Packard (HPQ) spinoff Agilent (A). Since then, the Old Economy stock has soared 236% to a new all-time high, while the supposed New Economy stock has fallen 71%.
  • On March 31, a couple of weeks after the Nasdaq peak, S&P removed auto-parts retailer Pep Boys (PBY) and replaced it with data-storage software maker Veritas Software (VRTS). The former is up 243% since, while the latter is down 82%.
  • Those are but two examples. Now multiply by 12, and you will get a sense of how destructive S&P's decision to actively manage its index in 2000 turned out to be. From the end of 2000 through Wednesday's close, the tech stocks added to the S&P 500 that year are down 65% collectively if you include the ones it has since removed, such as BroadVision ( BVSN) and Conexant ( CNXT), and it is down 60% if you exclude stocks the index later expelled. The index overall is down only 16.5% over that span.

    Paling Against the Dow

    Another way to mull what might have been is to compare the S&P against another benchmark, the Dow Jones Industrial Average. That warhorse, which is the subject of very little indexing, did not make any tech stock additions in 2000, though it added four stocks in 1999. The Dow is actually up 10% in the five years since March 10, 2000, while the S&P 500 is down 12%.

    S&P did not return my call for comment on this story, but for the record its argument in the past has been that its job is only to reflect the market, not to lead it. In its press release on Wednesday, S&P noted that in February 2000, technology issues accounted for 35% of total market capitalization, and that six of the top 10 issues in the S&P 500 by market value were techs -- representing a combined market value of $1.8 trillion. S&P noted in the release that the combined market value of those six companies alone has declined $1.11 trillion, and that the representation of all tech stocks within the S&P 500 now stands at 15%, down $2.3 trillion from five years ago.

    S&P has never professed to have a brilliant set of portfolio managers at the helm of its index. Its index stockpickers that year, as probably now, were a mix of economists, journalists and marketing executives. In contrast, many actively managed large-cap blend funds with veteran professionals at the helm did a lot better over the past five years. A few were ( SLASX) Selected American Shares, run by industry veteran Chris Davis, up 17% in the past five years, 29 percentage points better than the S&P 500; ( DODGX) Dodge & Cox Stock, up 92% in that span; and ( MPGFX) Mairs & Power Growth, which is much more diversified than it sounds, up 117%. All continue to be a better bet than the index.

    In sum, in this anniversary month, it's worth observing that S&P failed investors in that critical year with its faddish shift to tech stocks, and continues to deny its active role in wealth destruction. And so, those financial consultants who push S&P 500 index investing due to its lower costs disregard the oldest axiom in the book: You get what you pay for.

    Click here to read a letter about this story.

    Jon D. Markman is publisher of StockTactics Advisor, an independent weekly investment research service, as well as senior strategist and portfolio manager at Pinnacle Investment Advisors. He also writes a weekly column for CNBC on MSN Money. While Markman cannot provide personalized investment advice or recommendations, he welcomes column critiques and comments at jon.markman@thestreet.com.

    Interested in more writings from Jon Markman? Check out his newsletter, TheStreet.com Value Investor. For more information, click here.

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