A managed index?

By DAVID MOON, Moon Capital Management
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 dollars.

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 unmanaged index?

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).

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