Weeds out speculative, marginal firms

S&P 500

Dollars & Sense

January 12, 2003|By David Kathman | David Kathman,MORNINGSTAR.COM

What is the objective of the S&P 500 index? Standard & Poor's has a statement on what stocks may go into the index (leading companies in leading industries), but does not seem to say what this represents.

That's not a bad question to be thinking about right now, when the S&P 500 is being trotted out as a year-end benchmark for all kinds of stocks and funds. The short answer to your question can be found in a document from S&P's Web site, which says: "Standard & Poor's U.S. indices are designed to reflect the U.S. equity markets and, through the markets, the U.S. economy. The S&P 500 focuses on the large-cap sector of the market; however, since it includes a significant portion of the total value of the market, it also represents the market."

This description raises some new questions. Is the S&P 500 supposed to represent large-cap stocks or the market as a whole? The answer is yes to both to some extent. While the S&P 500 isn't limited to large-cap names, such stocks have the biggest influence on its performance because the index is market-cap-weighted. The S&P 500 does serve as a pretty good proxy for the overall market, but with some differences. To get a better handle on what the S&P 500 is and what it isn't, we'll need to dig a little deeper.

First of all, it's important to remember that the S&P 500 is not just a passive index of the 500 largest companies in the United States. Rather, the stocks are actively chosen by a committee based on a set of guidelines laid down by Standard & Poor's. Only U.S.-based companies are allowed; seven Canadian and European firms that had been grandfathered in were kicked out in July. Holding companies are not allowed (which is why Berkshire Hathaway is excluded despite a market cap that ranks among the 20 biggest in the United States), but the committee just decided in October 2001 to start allowing real estate investment trusts.

Companies must be publicly traded for at least a year before they can be included, and they must show four straight quarters of operating profits, which excluded plenty of hot tech firms during the stock market bubble.

There are no absolute criteria for size. Though the committee prefers market caps of at least $3 billion or $4 billion, the market caps in the S&P 500 actually range from about $200 million to $300 billion. But since the index is market-cap-weighted, larger companies naturally tend to dominate the index, and in fact they do so to a greater extent than in the market as a whole.

Vanguard 500 Index Fund, which tracks the S&P 500, has an average market cap of $45.5 billion, while Vanguard Total Stock Market Index, which tracks the much broader Wilshire 5000, has an average market cap of $27.6 billion.

One reason for this tilt toward large stocks arises from a further standard: S&P tries to keep the sector weightings of the index in line with the broader market, and within each sector, only "leading companies" make the cut.

Leaders in any industry will naturally tend to be bigger and more valuable than the laggards. Combined with the exclusion of money-losing and illiquid companies (which tend to have lower market caps), this skews the S&P 500 toward large caps with higher valuations. Indeed, the average stock in Vanguard 500 Index's portfolio has a forward price to earnings ratio of 16.3 and a price/book ratio of 2.2, vs. 15.9 and 1.9 for Vanguard Total Stock Market.

But there's a lot of subjective judgment in deciding which companies are the leaders in their industries. The S&P committee has quite a bit of leeway in deciding which stocks to add to their indexes - so much so that Bill Miller of Legg Mason in Baltimore likes to say that the S&P 500 is actually an actively managed portfolio rather than a true index.

While the representation of tech stocks in the S&P 500 has risen in recent years, that's because tech stocks have become a more important part of the overall market that S&P is trying to track.

Sure, the S&P 500 would have performed better since 2000 had it kept Old Economy stocks like Rite Aid and Nacco instead of replacing them with tech names like JDS Uniphase and Agilent, but then it would have been less representative of the market. The purpose of the S&P 500 is not to chase the best performance possible, but to provide a proxy for the U.S. stock market that excludes the most marginal or speculative companies. In that regard, it does a pretty good job.

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