By DAVID MOON, Moon Capital
November 14, 2004
Did you beat the S&P 500 last quarter? What about last year?
It is a notion that preoccupies investors. And for silly reason.
Proponents of worshiping at the S&P 500 altar are quick to point out that
most managers don’t beat this collection of 500 large US companies. Some
investors simply buy index funds that mimic the index. Others hire
managers and buy mutual funds that are obsessed with their daily, monthly and
quarterly “tracking error,” that is, their deviation from the S&P 500
return. In an attempt to reduce their tracking error, these managers
construct portfolios with fewer than 500 stocks, but still very similar to the
S&P 500. These “closet indexers” almost never tell their clients – and
they sometimes refuse to admit to themselves – that they are charging fees for
managing money when someone else is actually making the investment decisions:
the folks who construct the S&P 500 index.
It is a widely accepted myth that the S&P 500 index is an unmanaged group
of stocks. Not true. It is actively managed by a group of folks
unknown to most investors. And some recently planned changes to the index
are going to have ramifications for millions of investors and trillions of
The rights to the S&P 500 index are owned by book and magazine publisher,
McGraw Hill. A committee of McGraw Hill employees decides what stocks are
in the index. They get together and discuss what companies, in their
opinions, best represent the entire US economy. Following 9/11, the
committee considered dropping all airlines from the index. This is an
The most recently announced change will adjust the relative weightings of all
500 stocks in the index. (The change will occur in two steps over a
year.) Currently, the companies impact the return of the index in
proportion to the relative size of each company. A company with a market
capitalization of $100 billion has twice the impact on the S&P 500 return
than a $50 billion company. The new system, however, will reduce the
impact of companies with insiders who own a large percentage of the stock.
The president and CEO at Microsoft own 14 percent of the company’s shares.
Microsoft’s weighting will drop. So will companies such as UPS and
MetLife. Insiders own 40 percent of Campbell Soup; its weighting in the
index is about to decline significantly.
In all, the McGraw Hill managers will “sell” portions of 100 stocks and
increase the weighting of the remaining 400.
Index funds will have to sell shares of those 100 stocks, while adding to the
shares of the 400. Analysts estimate that index funds alone will have to
sell over $9 billion worth of Wal-Mart. And this doesn’t even count the
shares the closet indexers will have to sell. One supposed active manager
recently admitted to selling more than 500,000 shares of Wal-Mart as a result of
this shift in index weighting. I wonder if they pass along a portion of
their management fee to McGraw Hill?
David Moon is president of Moon Capital Management, a
Knoxville-based investment management firm. This article
originally appeared in the News Sentinel (Knoxville, TN).