History of the S&P 500's Flaws

The S&P 500 (SNPINDEX: ^GSPC  ) is the most popular stock index in the world. But it's also incredibly flawed.

Why? Because it weights its 500 components by market capitalization, which can skew it toward some of the market's most expensive stocks.

Last week, I asked Robert Arnott, CEO of Research Affiliates and a pioneer of alternative forms of indexing, a simple question: If weighting by market capitalization is so flawed, why is it so popular?

Here's what he had to say. (Transcript follows.)

Morgan Housel: If weighting by market capitalization is so flawed, why has it been so popular?

Robert Arnott: Weighting by market capitalization came along as a strategy in the early '70s. Cap weighting was first popularized by the S&P. It really came into its own with the launch of the S&P 500 in 1957. The S&P 500 was never intended as a strategy; it was intended to measure how the market is performing. And it's only 15 years later that people latched on to this. This beats most active managers, or, put a different way, most active managers can't beat this index.

Well, that's true, because the market consists of passive indexers and active managers. Take the passive indexers out of the picture, and what's left is going to look the same as the passive indexers, by definition. So active managers, by definition, have to collectively match the market minus their costs. So of course, most will underperform.

Now, because it beats most active managers, it gained a lot of traction. It also gained traction from finance theory; the efficient market hypothesis came along and said stock picking is a waste of time. Capital Asset Pricing Model was published in '64, and in a footnote, actually, it noted that the cap-weighted market was the mean variance efficient market portfolio, and you cannot beat it on a risk-adjusted basis if all of the underlying assumptions of cap M are true.

That's fine, but those underlying assumptions aren't true. And so cap weighting enjoyed a tailwind from finance theory, saying this is the right way to do it. By beating most active managers most of the time, by having finance theory back it up and say this is the right way to do it, it gained tremendous traction and people didn't look at alternatives. Just imagine if in 1957 the S&P had said, "Here's an S&P 500 that tracks the market. It's cap weighted, and by the way, we're doing a sister index, S&P Profits 500, that weights companies by their profits." The latter would have trounced the former in live experience and cap-weighted indexation would never have gained popularity.

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  • Report this Comment On December 20, 2012, at 9:33 PM, lngtrmcptlgns wrote:

    I have a huge amount of respect for Mr Arnott for challenging the utter nonsense of a "strategy" that composes an index based on cap weighting.

    If you invest in an S&P index fund, you are embracing this strategy to build a part of your own portfolio.

    I actually do own such an index because I love the low cost of index funds (and my 401K only offers three index funds), but I wish it weren't cap weighted.

    It is my ONLY way to get exposure to US large caps through the low-cost of an index fund (in my 401K).

    I applaud Mr Arnott and all of the lawsuits forcing 401K plan providers to open up the choices available to plan participants.

  • Report this Comment On December 20, 2012, at 9:55 PM, lngtrmcptlgns wrote:

    Equally non-sensical is the long-standing tradition of calling the cap-weighted S&P 500 "the market" and using it as THE benchmark "to beat".

    What idiot started this and why do financial journalists sheepishly allow it to perpetuate unchallenged? (Morgan excluded, who challenges all of the nonsensical aspects of anything related to investing, which is why I sheepishly read all of his articles)

    Not to mention the fact that the version of the S&P 500 that is often cited in articles does not include reinvestment of dividends (although S&P index funds do)!

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