Asymmetrical Information

From the desk of Mindles H. Dreck:

Will I be able to play the piano, Doc?

This column about the S&P 500 reminds me of people who spray insect repellent on bugs and complain when it doesn't kill them.

Daniel Gross, writing in slate, accuses the S&P 500 of being a mislabeled "actively managed" product, a "villain" of the bubble and not the "conservative", "safe" or (insert mom-and-apple-pie value here) product we were all told it was:

For decades, investors have regarded the highly diversified Standard & Poor's 500 as a safe place in which to plow long-term investments. For most of the '90s, Americans were hectored to invest their money in S&P 500 index funds. Champions of the S&P 500 boasted incessantly about how S&P index funds crushed most mutual funds and stock pickers, all while charging lower management fees. But in the past two years, the safe S&P 500 has proved to be even more dangerous than the rest of the market. While the Dow is off 26.6 percent from its 2000 peak, the S&P 500 is off a whopping 40.6 percent.

The index is one of the more unlikely villains of the bubble. Despite perceptions, the index is not a passive investment vehicle. Instead, S&P is constantly choosing new stocks and booting old ones. And in the past few years, S&P's modus operandi—which receives surprisingly little scrutiny—led it, essentially, to recommend that investors buy highly speculative companies at or near their tops.

First, let's get one thing clear: The S&P 500 is intended to represent the broad market of U.S. equities, nothing more, nothing less. This it does quite well, as you will see in this regression analysis of monthly returns from various indices to the Wilshire 5000. The Wilshire 5000 actually contains close to 7,000 stocks, representing the entire exchange-listed universe. It is the ultimate broad market benchmark. As you can see, the S&P 500 is a near statistical match for the Wilshire 5000. It has a R-Squared of 95% to the broad market, placing it fourth after three indices with many more stocks. Those of you familiar with the alpha and beta terms will see the S&P 500 is a close match from a return and relative volatility perspective as well.

Now, the reason S&P "constantly choos[es] new stocks and boot[s] old ones" is simple. Like most every other index in use for this purpose, the S&P 500 is a "market cap.-weighted" index. The reason stocks like Qualcomm and Yahoo found their way into the index in 1999 was because they had grown to be very large in terms of the total dollar value of their shares. To not include them would have reduced the degree to which the S&P 500 mimics the index. An active bet (by definition against the market as a whole) would have been to exclude them, not include them. The index reflects what the market bought up. Active managers second-guess the market, indices copy it.

If you wanted to create a group of vehicles that were representatives of "cars" in the U.S., would you eliminate GM products just because you think they are crap? Fine, but your group is no longer representative. People drive Chevies whether you like them or not. So it goes with index products.

We have met the villain, Mr. Gross, and he is us....

I have my qualms with the S&P committee process, but I would hardly accuse them of villainous active management. Russell uses a pure market-cap. ranking process. It has the virtue of complete transparency, but equity traders arb the heck out of stocks that will be added each year, causing all kinds of non-fundamental behaviors. Between the Russell 1000 and the S&P 500, its six of one, half a dozen of the other.

If you would like to see some REAL divergence between indices intended to track the same assets, check these out:

• S&P Midcap vs. Russell Midcap


• S&P Smallcap vs. Russell Smallcap

Now THOSE are serious differences. The explanation is very market-oriented, but if you're interested I'll try to post it.

Posted by Mindles H. Dreck at August 5, 2002 01:31 PM | TrackBack | Technorati inbound links