Will the Real S&P 500 Please Stand Up?

If you have an interest in investing, or you have a work related 401k, a personal/Roth IRA or any kind of retirement account (or investment management account), then you probably know that bluest chip of indexes, the Standard’s and Poor’s 500 or simply S&P500.

It’s the benchmark index for the US economy, every investment portfolio, and everything in between.

I myself have advised people to start their investment goals by buying the SP500 (I still stand by this, btw).

But how would you like to know a little secret? The current S&P 500 isn’t quite based on the same methodology that it used to be. What do I mean?

The old S&P 500 used to contain non-US multinational companies that had a significant presence in the US. Like Shell. Or Nestle. Or Toyota. At some point, those were kicked out of the index to leave only those companies who were wholly US owned. That took out huge companies, with heavy growth extracted from US markets but no longer represented in the SP500.

Now to the second change. Any index is a composition of different items (in this case stocks) in specified ratios. And the SP500 used to be weighted on market cap alone. Then around 2005, the publishers decided to introduce a float adjusted weighting (the float is the percentage of a companies shares trading freely on the open market). According to the new methodology, companies that have more liquidity or higher float, gets more weighting which means the index buys more of them, and companies that have less float get less weighting. It sounds academic, but it’s more than that.

To use the analogy referenced by one of the research papers I read, consider Microsoft when it first IPO’ed. As a young, fast growing company at the time, more than half it’s shares were held by insiders, Bill Gates and a lot of early employees.  Facebook, or most high growth entrepreneurial companies share this characteristic. At this time, SP500 going by its current methodoloy would have lowered the weighting of Microsoft, making whoever bought the index buy less of the company exactly when it has the most promise. Eventually, towards the height of the Dotcom bubble, just before the stock collapsed and then entered a period of stagnation, insiders began selling off their holdings into the market, increasing the float. The current SP500 would have increased the stocks weighting at this time, making it a bigger component of the index. The buying public would essentially be buying into the company when it has no growth in front of it anymore.

There are a ton of other little changes like this. It’s no longer your grandfather’s S&P 500.

What this means is that today’s SP500 is almost guaranteed to return less than it did historically. Which, funny enough makes it easier to beat. But since to me passive investing is still the best path to both returns and safety, I still encourage buying the index. You could supplement that by dedicating a small amount of your portfolio to high growth companies, some of those foreign stocks with top notch balance sheets and earnings, and a few wild cards.

If you want something that offers the full protection of an index with slightly better returns, consider Vanguard’s Total Stock Market Index and Total International Stocks Index.

I’ll always believe that one of the best ways to invest passively is to Vanguard it. My portfolio is a full 60% in my Vanguard IRA growing passively. My active stock picks amount to less than 30% and everything else is really wild carding or gambling for the sake of learning, speculation and simply honing my abilities.

At the end of the day, I just want to share what I learn to inform your thinking. I didn’t know this about the S&P until very recently. Hope it helps your investment needs.

Go forth and win.

Eke.

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4 thoughts on “Will the Real S&P 500 Please Stand Up?”

  1. Weird you should mention this because only three days ago I was mentioning these changes to a friend, to roaring disbelief, I might add. And I thought, hey maybe someone should tell other folks this. The original thought behind having s&p on ones portfolio was the assured returns AND safety. It’s like your beautiful long distance girlfriend gaining 20 pounds and randomly forgetting to mention.

    Hedge funds outperform the s&p (more often in bearish markets (no brainer)). With these handicaps, maybe even more so. And they aren’t too far out of the reach of the common man (networth <1m) anymore. Heard of some startup trying to decentralise hedge fund participation. Alternative, ahoy?

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      1. Checked them out. It’s probably best for an investor with a bigger footprint, chasing diversification on the short term. Like someone trying to drop $100,000 for the bear market hedge.
        I’m skeptical about them throwing an additional 0.5-1% on top of hedge fund fees, considering the latter already cut a huge chunk of performance.
        I’d rather just Vanguard it to be honest, if I needed a hedge like this. Or use Motif Investing to create my own pseudo ETF.

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