S&P 500 - Questionable guide for investors

By DAVID MOON, Moon Capital Management
February 19, 2006

Popular opinion to the contrary, the S&P 500-stock index is not an unmanaged index of stocks.

It's managed by a group of folks at McGraw-Hill, the publishing company that owns Standard & Poor's. And it seems that the changes to the index made by these publishing money managers actually have a negative impact on both the return and the volatility of the index.

A recent study of the S&P 500 by Jeremy Siegel (a professor at the Wharton School) and Jeremy Schwartz (a senior analyst at Wisdom Tree Investments) discovers that when the Standard & Poor's folks remove a stock from the 500 index and replace it with another, the change is more likely than not to cause the subsequent returns of the index to be lower than if the index had simply been left alone.

All this matters to investors because the S&P 500, an assemblage of the largest stocks traded in the U.S., epitomizes the diversification that is supposed to reduce investors' risk ' the volatility with which stock prices move up or down. That's why it's traditionally the benchmark most used by index funds, those mutual funds that simply try to match the market.

Created in 1923, the index was expanded to its current complement of 500 stocks in 1957. But the stocks within that group have hardly remained constant. From 1957 to 2003, a total of 917 stocks were added to the index as companies shrank, failed or were merged, acquired or spun off.

The two Jeremys looked at several different methodologies for handling dividends and recapitalizations of all sorts. In every case, the ultimate return of the S&P 500 would have been higher had the index components remained unchanged.

The name of the unchanging index would have needed to regularly change, because as companies went private, were acquired or filed bankruptcy, the number of stocks in the index would have declined. But even though the number of stocks in the index declined, the volatility of the index also declined.

Increasing the number of stocks had the opposite effect of what we're told diversification is supposed to do. That is, as Standard and Poor's increased the number of stocks from the 'do nothing' portfolio, it managed to actually increase the volatility ' the supposed riskiness ' of the portfolio.

What's more, the 'do nothing' portfolio was significantly more tax efficient than the actual index, as there were many fewer transactions to create capital items.

Here are my observations from the study:

' The S&P folks are more likely to add a stock to the index after it has significantly increased in price, increasing the odds that it adds stocks at a time they are overvalued. The addition of WorldCom, Global Crossing and Quest Communications in the late 1990s is an example. The index added 36 technology companies in 1999 and 2000. Not great timing.

' Stocks are likely to be removed from the index after periods of underperformance, or at times they may be more likely to be undervalued.

' The relationship between the number of stocks in a portfolio and risk is misunderstood.

' Because S&P manages the index to represent the largest or most generally popular stocks, the index is a questionable guide for investors.

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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