THE CASE AGAINST INDEXING

In April of 2004, Dow Jones & Co. announced that it would replace three companies that were constituents of the Dow Jones Industrial Average. All three stocks fell sharply, while the three additions were up nicely. What’s surprising is not the widely noted phenomenon known as “the index effect,” but that it would be so evident in the Dow, which does not have the index following of the current king of the benchmarks, the S&P 500.

It doesn’t take a lot of imagination to picture the selling pressure on a stock dropped from the S&P 500, or the buying pressure on new additions. To get a sense of how many investors that might affect, the number of index funds grew from 23 in 1990 to 708 in 2004, with the S&P 500 by far the most popular model. According to Morningstar, the total assets of just the mutual fund indexers exceeded $607 billion by mid-2004.

Obviously, there’s more to “passive” investing than first meets the eye. In fact, indexing strategy has been coming under increased scrutiny, as the funds tied to the S&P 500 slip in relative performance and the underlying structure of the S&P 500 is questioned.

But who makes these decisions and what are the criteria? One of the most astute observations in this area was published by Jon Markman, Managing Editor of MSN MoneyCentral under the title “The S&P 500 is a Mutual Fund – and a Bad One at That.”

He cites the poor relative performance of the S&P 500, blaming it largely on “a series of reckless decisions to add high-momentum technology stocks” to the Index in the year 2000. He notes that of the 45 stocks that were added to the S&P 500 in 2000 and still remain in the Index: 22 are down more than 50% since their addition, 13 are down more than 75% and eight are down more than 85%. The composition of the S&P 500 is not a purely quantitative exercise, but is decided by committee. The committee, chaired by S&P’s Chief Economist David Blitzer, seeks to create a mix of companies that is representative of the market in general. This decision-making process is put to the test when an S&P 500 company runs into trouble. Take for example, Enron, which hit a high of over 89 dollars in September of 2000. The day it left the S&P 500 (November 29th, 2001) its price was 36 cents.

A cover story in the May 2002 issue of Institutional Investor magazine asked, “Is time running out of the S&P 500?” The story sources Nobel Laureate William Sharpe, whose work on efficient markets helped set the stage for the boom in indexing. “The S&P 500 is not the best benchmark available,” he says, while his co-Nobelist, Harry Markowitz bluntly calls the S&P 500 “a goner.” In short, the problem with the S&P 500 is that “so much money is now indexed to the S&P . . .that it has become grossly distorted by concentration, warping the market it’s meant to mirror.”

Since the S&P 500 is a capitalization weighted index, indexers are also subject to the emotional momentum of the market. The best example is the way that S&P 500 index funds mirrored the technology bubble, by capturing their fair percentage of the rampant overvaluations of the late 1990s. In this case, passive investing meant following the herd, even when it strayed over the edge.

Wharton Professor Jeremy Siegel has gone on record suggesting that the S&P 500 Index could face some real performance headwinds. He sees active managers having the edge going forward, as the very existence of indexing money pushes up valuations, especially for those companies at the largest end of S&P 500 capitalization.

The problems with S&P 500 Indexing are becoming clearer, as more and more active managers outperform the benchmark. As previously mentioned, the constant change in the Index’s composition give it elements of active management, but without the nimbleness or discipline of an experienced active manager.

Investors in index strategies had a reasonable expectation that the broad diversification of their investments would provide protection in a down market. As the past few years have shown, Indexes are no place to hide from a bear market. Instead, risk-sensitive active managers have done a much better job of protecting their investors from the excesses that were fully expressed in an Index fund in early 2000.

It’s no wonder that institutions and individuals are rethinking the positioning of their core holdings that have suffered from indexing strategies. After all, indexing does a wonderful job of matching the herd – but as the markets have recently demonstrated, the herd doesn’t always know where it is heading.

(Published by Concord’s partner, Madison Investment Advisors, Inc.Summer 2004.)

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