An Index Insurrection

Passive indexing has many detractors. One even calls the S&P 500 a poorly managed mutual fund that has made "epic blunders." A look at the numbers, however, shows it has done an admirable job of tracking the total market, and it's still a fine choice for most investors.

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By Rex Moore (TMF Orangeblood)
December 10, 2002

One of the cornerstones of The Motley Fool financial philosophy is investing in index funds. As stated in Step 4 of our 13 Steps to Investing, we believe an appropriate index fund (such as one that tracks the S&P 500) can be the first and last stop for many people -- and one that will help them achieve financial independence over the long haul.

Index investing is not without its critics, however. Several months ago, I addressed one of them who said buying the S&P 500 could be "disastrous." In the end, I concluded, our position was still the same. "We still firmly believe that an index fund that tracks the S&P 500 or the total market is a fine place for your money. Some of your money, or even all of your money that you have decided to allocate to the market."

Since then, another type of criticism has been leveled against the S&P 500. According to Jon Markman, a portfolio manager at Pinnacle Investment Advisors, the S&P is nothing more than a poorly managed mutual fund. In a series of articles, he has blasted those in charge of adding and subtracting stocks from the various S&P indexes and called passive big-cap indexing "just another dumb fad." Those are strong words, and they caused at least one Fool to email us asking for our take on the matter. I, of course, am more than happy to oblige.

The S&P 500 is not passive
One of the big advantages of index funds is that they are passively managed. Unlike an actively managed fund that employs managers and researchers in hopes of finding good investments, passive funds simply buy and sell according to the index they track. It requires a minimum level of support, and as such expenses are extremely low compared to actively managed funds. That means more of your money goes toward the investment, and much, much less toward paying for salaries.

Markman says the S&P 500, itself, is not passively managed, and he's right. There's an eight-person committee that decides which companies are added to the list and which are dropped. But while the S&P is not passive, the funds that index it -- such as the biggest of them all, the Vanguard 500 Index Fund -- are. Thus, the fact the S&P 500, itself, is actively managed does not in any way negate the low-cost advantage of funds that mimic it.

Markman's point, though, is the S&P committee blundered by using some subjective means to pick companies (especially during the height of the bull market) instead of following a predetermined set of guidelines. He claims the members tried to play "keep up" with the soaring Nasdaq in 2000, and unwittingly bought several tech companies near their all-time highs, only to watch them plummet when the bubble popped. As he puts it, the committee made a terrible decision to "mirror the mania."

The S&P would counter that its role "is to reflect the U.S. equity market" and that's all it was doing. As one of Markman's articles states, "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."

Did the committee make an "epic blunder," as Markman puts it? It's certainly easy, in hindsight, to criticize the addition of such companies as Lucent (NYSE: LU), Dynegy (NYSE: DYN), Corning (NYSE: GLW), and JDS Uniphase (Nasdaq: JDSU), which have lost 75% to 97% of their value.

However, if the members had tried to select companies based solely on their expected future stock performance, they would be actively managing the index even more than they already are. It's not their job to be stock pickers; they are simply trying to include the 500 "leading U.S. companies from leading industries."

Markman says the committee's decisions have caused the S&P 500 to perform poorly relative to other key benchmarks. As an example, he noted last June that the index was down 34% since the start of 2000, more than 50% worse than the Dow Jones Industrial Average.

But the Dow is a much narrower index, comprised of 30 U.S. industrial giants, and not at all representative of the total market. Meanwhile the S&P has actually done an excellent job mirroring the total market, even during the past two years, when its committee allegedly blundered.

We can tell by comparing it to the performance of a couple of real benchmarks. The Wilshire 5000 tracks virtually all publicly traded U.S. companies (which number over 6,500 in all). The Russell 3000 measures the performance of the 3,000 largest U.S. companies, which represent about 98% of total market capitalization.

How has the S&P 500 stacked up against these two since the start of 2000? The returns are remarkably close: The S&P lost 39% over that period, and the Russell and Vanguard Total Stock Market fund -- which tracks the Wilshire -- both lost 38%. A chart comparing them shows three nearly identical lines.

Want more proof than just the last couple of years? The Washington Post's James K. Glassman highlighted research in a recent column that compares the Wilshire 5000 and S&P 500 returns over the past 28 years. The former gained 2,322% during that time, while the latter rose 2,247%. In other words, $10,000 invested in the Wilshire would have netted you just 4% more during that time. And over the past 10 years, the S&P has outgained the Wilshire by a slight 10.1% to 9.4%.

Two years, 10 years, 28 years. These results simply do not indicate the S&P has lost any relevance as a proxy for the market.

Our take
So fear not, S&P 500 investors. Your index does a great job of mirroring the total market, which is all we ever expected it to do. If you'd rather track the Wilshire 5000, that's fine, too. Either way, you're likely paying an extremely small expense ratio: just 0.18% in the Vanguard 500's case, compared to the average actively managed mutual fund's charge of 1.4%. (Though beware that some companies offer index funds with much higher ratios than Vanguard's; be sure to check your prospectus.)

So, yes, the average actively managed fund has an expense ratio seven times higher than Vanguard's, and the majority of them fall short in performance. Nothing's changed... the S&P 500 is still a fine choice for your money.

Rex Moore has never eaten gruel, but is willing to try. He owns no companies mentioned in this column. The Fool has a tasty disclosure policy.