SuperModels Community
Join the discussion in the MSN Money SuperModels Community.
| | SuperModels
The S&P 500 is a mutual fund and a bad one
Countless individual investors have tied some three-quarters of a trillion dollars to the "passive" index. In truth, the index is a poorly managed fund with the recent track record to prove it.
By Jon D. Markman
One myth that appears to be imploding along with the market is the notion that investors should passively buy the market via the S&P 500 Index ($INX) rather than buying individual stocks.
Its not just that the S&P 500 is down a bunch this year or last. Its that the index has done so poorly relative to other key benchmarks for reasons that look suspiciously like pilot error: The index is down 34% since the start of 2000 through June 25, more than 50% worse than the decline of its arch-rival, the Dow Jones Industrial Average ($INDU), largely because of a series of reckless decisions to add high-momentum technology stocks in that pivotal year.
Of the 45 stocks that Standard & Poors added to its benchmark index in 2000 that remain in the index, 22 are down more than 50%. Thirteen of those are down more than 75%, and eight are down more than 85%.
If a major institutional money manager had posted a record like that, he would have been run out of town. Yet for some reason, Standard & Poors has managed so far to skate clear of its measure of blame for the ruin of millions of retirement accounts entrusted to its care in the form of mutual funds and pension funds fated to shadow its wrong-way run. Why?
S&P 500 is not passive at all
This is not a trivial matter. By some estimates, nearly three-quarters of a trillion dollars are managed worldwide in synch with the S&P 500 -- making it without doubt one of the most widely held financial instruments on the planet short of U.S. Treasurys. The granddaddy of public funds in the category is also the nations largest fund -- the Vanguard 500 Index (VFINX), with $74 billion in assets. Investors in these funds have lost nearly 9% annually in the past three years, at a time when holders of more professionally managed funds owning a similar blend of large growth and value stocks, such as the Dodge & Cox Stock Fund (DODGX), have gained as much as 7.3% annually.
One reason that S&P, a division of McGraw-Hill (MHP, news, msgs), has not come under fire for the indexs poor performance is that most investors seem to think that it is a quasi-scientific measure that depends on little or no human intervention. The truth is that an eight-person committee of S&P bureaucrats -- editors, business managers, quantitiative analysts and an economist -- wield a heavy hand in its purportedly passive management. There are no professionally trained or regulated money managers on the team, according to Elliott Shurgin, vice president for index services at S&P.
Defenders point out that the Russell 3000 ($RUA.X), a measure of the markets largest 3,000 stocks, has done about the same as the S&P 500. Yet as risks of the S&P orthodoxy have become more apparent, a few voices in the industry have emerged to speak against it. Alan Newman, an analyst at brokerage H.D. Brous & Co. in New York, said in an interview that he believes Vanguard, among others, has done a very great disservice by advancing the thesis that instead of trying to beat the market you should buy the market. The problem is that the S&P 500 isnt the market -- its an actively managed fund, and a poorly managed one at that.
This is not just a question of one company picking better stocks than the other. Its a question of a flawed design that rewards sector momentum over common sense. Unlike most index publishers, such as the Nasdaq and Dow Jones, Standard & Poors adds and subtracts stocks from its three broad indexes -- the large-cap 500, the Midcap 400 ($MID.X) and the Smallcap 600 ($SML.X) frequently in accordance with a largely subjective list of criteria that includes market capitalization, liquidity and their representation of industrial sectors.
Its the latter criteria that got S&P into trouble in 2000 as it tried to keep pace with the explosive 1999 performance of the tech-heavy Nasdaq 100 ($NDX.X). Every month a number-cruncher at S&P adds up the total capitalization of all 9,000 or so stocks traded on U.S. exchanges, and determines the percentage representation of each broad industrial sector, such as technology, health care and capital goods. After technology stocks roared into favor in the late 1990s, S&P found that the market had given an 18% weighting to tech stocks while its index only had a 14% weighting. So the committee considered itself obligated to raise its weighting in tech stocks in short order. As a result, not only did S&P 500 index managers yank out the stocks of seemingly stodgy retailers and industrials to add shares of technology companies such as JDS Uniphase (JDSU, news, msgs), Veritas Software (VRTS, news, msgs) and Broadcom (BRCM, news, msgs) near their historic highs in 2000, but because these decisions dont have a ripcord they then proceeded to hold them while many plunged 80%-plus. (Write me here if you would like a full list.) The committee did the same with new-age electric power producers Dynegy (DYN, news, msgs) and Calpine (CPN, news, msgs); biotechs MedImmune (MEDI, news, msgs) and Biogen (BGEN, news, msgs) and business services provider Convergys (CVG, news, msgs).
In all, the stocks added by S&P to its index in 2000 are collectively down about 43% on average through June 25. (See my columns of Dec. 21, 2001 and Feb. 14, 2001, which reported that expelled stocks have generally performed better than added stocks in the past three years.)
Shurgin said his teams mandate is to reflect market weights in the indices -- thats the beginning, middle and end of the discussion. We are followers, not leaders. But that has proved to be an elusive and expensive theory, and S&P is now in the fight of its life to undo the damage before its index sinks into irrelevance and drags its lucrative licensing fees down with it. In the past 10 months, S&P has already removed three members of its ill-fated class of 2000 for what it calls lack of representation: BroadVision (BVSN, news, msgs), Sapient (SAPE, news, msgs) and Global Crossing (GBLXQ, news, msgs). And last week it announced plans to remove a fourth, Conexant Systems (CNXT, news, msgs).
Only a miracle rebound in the Nasdaqs fortunes will likely prevent S&P from removing at least two other companies that would not even qualify now for the Midcap 400 -- Vitesse Semiconductor (VTSS, news, msgs) and Power-One (PWER, news, msgs) -- as well as the much larger but equally damaged JDS Uniphase and Applied Micro Circuits (AMCC, news, msgs). Three technology stocks added in the class of 2001 that appear doomed for removal this year because of their shrunken market caps and prices under $5 are Palm Inc. (PALM, news, msgs), Ciena (CIEN, news, msgs) and PMC-Sierra (PMCS, news, msgs). And names added in prior years that seem equally unrepresentative of anything but debt or dishonor are Nextel Communications (NXTL, news, msgs), Corning (GLW, news, msgs), Nortel Networks (NT, news, msgs), Qwest Communications (Q, news, msgs) and Parametric Technology (PMTC, news, msgs). More pessimistic observers would also add Gateway (GTW, news, msgs), ADC Telecommunications (ADCT, news, msgs) and Lucent Technologies (LU, news, msgs), as well as non-techs Conseco (CNC, news, msgs) and AES Corp. (AES, news, msgs). All are trading at prices under $5 and have fallen 55% or more in the past year.
Said Newman: The end game is that there was a move over several years toward index funds, and now well have a move away from them as people become distressed to learn that their so-called passive investment vehicles were actively managed by drivers who didnt know how to hit the brakes on stocks down 80-90%.
QQQ investors stuck with bad stocks
Kenneth Safian, chief executive of Safian Investment Research in New York, says he thinks the problem arose because the S&P 500 and Nasdaq 100 are not true indexes measuring the U.S. economy or the strength of an investment philosophy, but rather are the products of marketing organizations with something to sell. These indexes dont represent anything but some managers hopes and dreams, he said.
Indeed, the irony for S&P is that since January 2000, the Nasdaq 100 has doubled the misery of the S&P by sinking 73%. Before explaining why this matters, first endure a little background.
The Nasdaq 100 was developed in 1985 to track the performance of the 100 largest non-financial companies traded on the exchange, says John L. Jacobs, chief executive at Nasdaq Financial Services. (There was already a Nasdaq Financial 100 Index to track large banking companies trading on the exchange.) Fourteen years later, the organization created a unit investment trust based on the index that trades under the symbol QQQ. It launched with an initial deposit of $14.9 million in March 1999 and quickly swelled with the ballooning interest in the many tech stocks traded on Nasdaq to assets of $6 billion by the end of that year and $22 billion by the end of 2000. That amount has not changed in the past two years, though Jacobs estimates that at least another $8 billion in institutional money worldwide directly or indirectly tracks the Nasdaq 100 -- bringing assets focused on the index to a whopping $30 billion.
Unlike Standard & Poors, Nasdaq rebalances its leading index according to strict statistical criteria once a year, on the third Friday of December. Essentially, all 5,000 or so Nasdaq stocks are ranked from high to low by market capitalization, and the largest 100 that have been public for at least two years and trade at least 100,000 shares daily make the index. If an index stock falls to rank 101st to 150th in market capitalization at the time of the rebalancing, it is given a one-year grace period before facing expulsion. If it falls below the 150th rank in any year or fails to regain the 100th spot or better in its grace-period year, the stock is expelled and replaced by the next-highest ranked Nasdaq member. The only major exceptions are companies that are delisted from Nasdaq, as Adelphia Communications (ADELA, news, msgs) was a few weeks ago.
This means that QQQ investors are thus forced to own absolute dogs for as long as a year after their crimes against shareholder value become evident to even the dullest active manager. And in bear markets characterized by heavy sector rotation, it means that stocks added to the index are typically inserted into QQQ owners portfolios at their historic highs just as their time to fade has arrived. (The same is true for the Russell 3000.)
In December 2001, Nasdaq expelled such under-$1 dot-com relics as CMGI Inc. (CMGI, news, msgs), Metromedia Fiber Network (MFNXQ, news, msgs), McLeodUSA (MCLD, news, msgs) and Inktomi (INKT, news, msgs) from the index only to replace them with 13 biotech and cable stocks that have gone on to repeat their elders swoon. The 13 new names in the Nasdaq 100 are collectively down 49% since inclusion on Dec. 21, 2001, which just about doubles the Nasdaq Composites ($COMPX) 25% collapse in the same period. Leaders of the catastrophe for passive Nasdaq investors, as shown in the table below, are mostly biotechs that benefited from hot money rotation last November and December: ImClone Systems (IMCL, news, msgs), down 86%; Sepracor (SEPR, news, msgs), down 83%; Protein Design Labs (PDLI, news, msgs), down 71%; and ICOS Corp. (ICOS, news, msgs), down 70%.
| Nasdaq 100 additions December 2001 | | Sym. | 12/21/01 close | 6/25/2002 | Change | | Express Scripts | ESRX | $47.99 | $52.00 | 8.36% | | Synopsys | SNPS | $58.48 | $52.88 | -9.58% | | CDW Computer Centers | CDWC | $51.89 | $44.47 | -14.30% | | Integrated Device Technology | IDTI | $26.04 | $18.80 | -27.80% | | Cephalon | CEPH | $74.75 | $48.11 | -35.64% | | Invitrogen | IVGN | $63.93 | $31.89 | -50.12% | | Symantec | SYMC | $33.95 | $31.70 | -6.63% | | Protein Design Labs | PDLI | $33.25 | $10.20 | -69.32% | | ICOS Corp. | ICOS | $59.81 | $18.00 | -69.90% | | Cytyc | CYTC | $26.93 | $8.10 | -69.92% | | Charter Communications | CHTR | $15.75 | $4.19 | -73.42% | | Sepracor | SEPR | $53.55 | $8.94 | -83.31% | | ImClone Systems | IMCL | $62.96 | $8.95 | -85.78% | | Total Chg. | | | | -45.18% | | Nasdaq Combined Composite Index | | 1,945.83 | 1,469.29 | -24.49% | | S&P 500 INDEX | | 1,144.89 | 1,003.17 | -12.38% |
|
Jacobs said his organization is studying the issue of the rebalancing of the index very carefully and could announce changes later this year. However, he insisted that he is not an asset manager and asked investors who have $30 billion in the pummeled strategy to note that current results are merely a reflection of the environment and that over the past 16 years the Nasdaq 100 had rewarded patience with a 693% gain, vs. 497% for the Dow Jones Industrials and 369% for the S&P 500.
If you havent got that kind of time left after losing 73% in the Nasdaq 100 since 2000 or 34% in the S&P 500, then perhaps now would be a good moment to complain loudly about your managers historic collapse and consider alternatives.
Fine Print
Lessons Learned? Stocks added to the S&P 500 in 2001 are collectively down only 8.5%, led by declines of 78.5% in Ciena, 65% in Mirant (MIR, news, msgs), 72% in PMC-Sierra and 65% in AT&T Wireless Services (AWE, news, msgs). Those were among the few technology or energy stocks added that year, as most were in business services or consumer services, such as big winner Concord EFS (CEFT, news, msgs), +51%, Pepsi Bottling Group (PBG, news, msgs), +49% and uniform services provider Cintas (CTAS, news, msgs), +30%. In 2002, S&P has continued its tradition of adding fast-rising stocks in the most popular industrial sectors to the S&P 500. In time, we will determine whether they were reflecting economic changes or simply the market momentum of regional banks, real-estate investment trusts, insurance and home improvement products. Top adds so far, in order of inclusion, are Plum Creek Timber (PCL, news, msgs), Ace Limited (ACE, news, msgs), Rational Software (RATL, news, msgs), Marshall and Ilsley (MI, news, msgs), First Tennessee National (FTN, news, msgs), American Standard (ASD, news, msgs), BJ Services (BJS, news, msgs), Apollo Group (APOL, news, msgs) and Simon Property Group (SPG, news, msgs) .
No Double Dip: Lakshman Acuthan, our favorite economist and managing director of Economic Cycle Research Institute, reports that his weekly leading index of economic indicators finished last week at a 36-month high. That means the recovery from the 2001 recession is still on track. So why the disconnect with stock prices? He says its because investors jumped to the conclusion that there would be a V-shaped recovery; instead, the recovery has been subpar. If the weekly leading indicators declines or stalls in the month ahead, he says it will only suggest a cyclical downturn in the growth rate, not a double dip of recession. The reason Im not shaking in my boots with the market crashing is that all of my indicators except for stocks are hitting highs, including commodity prices and the leading employment index, he said. So, yes, corporate governance is a negative and international tensions are a negative and they are shaving some growth off the economy, but they are not capable of knocking the economy back into a recession -- a window of vulnerability closes as the recovery takes hold, and now its virtually shut. Hes not an investment strategist, but suggests that growth in the recovery could potentially be most solid in the industrial and capital goods sectors. Watch for an advance in industrial capacity utilization statistics to monitor that idea; the next report is July 16. (click here).
P. Patch: A hedge fund manager whom I have called "Mr. P" first surfaced this year in a column on Jan. 30 with a forecast that the Nasdaq would sink to 1,580, the Dow Jones Industrials to 9,280 and the S&P 500 to 965. At the time, index levels were 1,934, 9,920 and 1,113. He later surfaced to declare himself constructive, which is Wall Street speak for bearish with an optimistic bent, and advised using declines to buy on dips. With the Dow at exactly his target level and the S&P not far away, he says he now believes the market will reverse for the better as soon as the end of the month or the first week of July for at least two reasons: Equity-income pension managers need to rebalance their funds by buying stocks and selling bonds; and tremendous stock-selling pressure from Arab countries over geopolitical issues will abate. He says he would be more certain of a lasting summer recovery if the Bush administration were to halt what he calls an anti-capitalist campaign against international fund flows.
| July 2002 -- 50-Stock StockScouter Portfolio | | Company | Sym. | Rating | 6/28/02 Close | | | Central Parking Corporation | CPC | 10 | $22.91 | | | Century Bancorp, Inc. | CNBKA | 10 | $27.37 | | | FNB Corporation | FNBP | 10 | $30.46 | | | Material Sciences Corporation | MSC | 10 | $14.02 | | | Prosperity Bancshares, Inc. | PRSP | 10 | $18.22 | | | Advisory Board Company | ABCO | 10 | $36.24 | | | Elcor Corporation | ELK | 10 | $27.65 | | | Harbor Florida Bancshares, Inc. | HARB | 10 | $22.19 | | | Virginia Financial Group, Inc. | VFGI | 10 | $32.06 | | | Brown Shoe Company, Inc. | BWS | 10 | $27.64 | | | Offshore Logistics, Inc. | OLOG | 10 | $23.89 | | | Oil States International, Inc. | OIS | 10 | $11.69 | | | Pacific Union Bank | PUBB | 10 | $17.48 | | | RemedyTemp, Inc. | REMX | 10 | $18.20 | | | IBERIABANK Corporation | IBKC | 9 | $40.54 | | | Old Second Bancorp, Inc. | OSBC | 9 | $36.74 | | | Willow Grove Bancorp, Inc. | WGBC | 9 | $11.73 | | | American National Financial, Inc. | ANFI | 8 | $15.48 | | | dELiA*s Corp. | DLIA | 8 | $5.10 | | | LabOne, Inc. | LABS | 8 | $26.40 | | | Sierra Bancorp | BSRR | 8 | $9.98 | | | Sports Authority, Inc. | TSA | 8 | $11.35 | | | ABM Industries Incorporated | ABM | 10 | $17.82 | | | Hawthorne Financial Corporation | HTHR | 10 | $32.41 | | | Republic Bancshares, Inc. | REPB | 10 | $20.17 | | | Republic Bancorp Inc. | RBNC | 10 | $14.94 | | | Angelica Corporation | AGL | 10 | $17.16 | | | NL Industries, Inc. | NL | 10 | $15.39 | | | Nara Bancorp, Inc. | NARA | 10 | $23.01 | | | Oriental Financial Group, Inc. | OFG | 10 | $25.00 | | | Seacoast Financial Services Corporation | SCFS | 10 | $25.07 | | | Stein Mart, Inc. | SMRT | 10 | $11.87 | | | Bally Total Fitness Holding Corporation | BFT | 9 | $18.70 | | | California First National Bancorp | CFNB | 9 | $16.08 | | | Fred's, Inc. | FRED | 9 | $36.78 | | | Frontier Oil Corporation | FTO | 9 | $17.38 | | | Genesco Inc. | GCO | 9 | $24.82 | | | Per-Se Technologies, Inc. | PSTI | 9 | $9.20 | | | Pope & Talbot, Inc. | POP | 9 | $18.72 | | | Sanderson Farms, Inc. | SAFM | 9 | $25.01 | | | Sharper Image Corporation | SHRP | 9 | $20.15 | | | Shoe Carnival, Inc. | SCVL | 9 | $21.34 | | | Stage Stores, Inc. | STGS | 9 | $34.74 | | | Wellman, Inc. | WLM | 9 | $16.70 | | | UTi Worldwide Inc. | UTIW | 9 | $19.77 | | | FBL Financial Group, Inc. | FFG | 9 | $21.60 | | | Hancock Holding Company | HBHC | 9 | $67.38 | | | Community Bank System, Inc. | CBU | 9 | $31.75 | | | Penns Woods Bancorp, Inc. | PWOD | 9 | $34.97 | | | Ashworth, Inc. | ASHW | 8 | $9.01 | | | | | | | | | | | | | StockScouter -- No Sector Bias | | | | | | Company | Sym. | Rating | 6/28/02 Close | | | Elcor Corporation | ELK | 10 | 27.65 | | | Offshore Logistics, Inc. | OLOG | 10 | 23.89 | | | Oil States International, Inc. | OIS | 10 | 11.69 | | | RemedyTemp, Inc. | REMX | 10 | 18.20 | | | American National Financial, Inc. | ANFI | 8 | 15.48 | | | LabOne, Inc. | LABS | 8 | 26.40 | | | Angelica Corporation | AGL | 10 | 17.16 | | | NL Industries, Inc. | NL | 10 | 15.39 | | | Genesco Inc. | GCO | 9 | 24.82 | | | Per-Se Technologies, Inc. | PSTI | 9 | 9.20 | | | | | | | | | | | | | StockScouter -July Short Candidates | | | | | | Company | Sym. | Rating | 6/28/02 Close | | | Peoplesoft | PSFT | 2 | 14.88 | | | SanDisk | SNDK | 2 | 12.40 | | | TIBCO Software | TIBX | 2 | 5.56 | | | Adaptec | ADPT | 3 | 7.89 | | | Amkor | AMKR | 3 | 6.22 | | | Research in Motion | RIMM | 3 | 11.38 | | | Triquint Semiconductor | TQNT | 3 | 6.41 | | | Macromedia | MACR | 3 | 8.87 | | | Lattice Semiconductor | LSCC | 3 | 8.74 | | | Micron Technology | MU | 3 | 20.22 |
|
While Jon Markman cannot provide personalized investment advice or recommendations, he invites you to send comments on his column to 7jonmail@microsoft.com. At the time of publication, he owned or controlled shares in none of the equities mentioned in this column.
|
