Stock Pickers Par Excellence - Standard and Poor's 500-Stock Price Index - Brief Article

Kiplinger's Personal Finance Magazine, August, 1999 by Manuel Schiffres

Funds guided by their picks match the S&P 500 year after year.

Here they are, seven of the savviest stock pickers on Wall Street, and among the least well known, too--which is precisely how their employer likes it. Once a month, usually on a Tuesday, they gather in lower Manhattan, just blocks from the major exchanges, to consider momentous decisions that can send stocks soaring or reeling. So astute are these people's choices that their best-known product has managed to match the performance of the widely watched Standard & Poor's 500-stock index each of the past 20 years--a record that most professional money managers would leap to embrace. Who are these wizards of Wall Street?

Actually, they are the S&P 500, inasmuch as they are the Standard & Poor's employees (two are not pictured) who determine which stocks enter and leave the most popular benchmark for judging the performance of fund managers. When the S&P announces changes in its index, affected stocks often soar or swoon as investors anticipate heavy buying and selling by index funds.

The S&P 500 is by far the favorite index of index

funds, those funds that attempt to mimic a specific market barometer. And no wonder: The performance of S&P 500 index funds over the past few years has been spectacular in absolute terms--as well as when compared with thousands of actively managed funds.

Consider Vanguard 500 Index, the biggest--with $82 billion in assets--and, at 23 years old, the eldest index fund. Just by owning the names in the S&P 500 in proportion to their weighting in the index, the fund has sped past 97% of all diversified U.S. stock funds the past five years.

America's growing affinity for indexing is changing the face of the fund industry. In the first four months of 1999, reports Financial Research Corp., index funds accounted for $3 of every $5 of net deposits into stock funds. Index funds account for almost 9% of all stock-fund assets, up from 1% at the start of the decade. Not surprisingly, two-thirds of those deposits find their way into funds that track the S&P 500.

Forgive our skepticism, but the trend makes you wonder whether investors are buying the rationale for index funds or merely following the time-honored tradition of buying what's been doing best lately. Or, as Ken Gregory, president of No-Load Fund Analyst newsletter suggests, for many investors indexing is merely "a momentum play on the S&P 500." If so, it raises the question of whether those investors understand what they're buying. Today's S&P 500 may be a lot racier than they think.

Such questions aren't meant to denigrate the beauty and simplicity of investing in index funds, in theory, they have one indisputable edge over their actively managed counterparts: lower costs. The expense ratio for a typical Vanguard index fund is about 0.2% a year, versus 1.4% for the average actively managed, diversified U.S. stock fund. That means that the index fund absorbs $2 a year of every $1,000 invested, compared with $14 a year for the average actively managed fund. On top of that, index funds rarely sell stocks. If the typical active fund turns over its portfolio, say, once a year, that adds another 0.5% a year in trading expenses--perhaps more if the fund specializes in small-company or foreign stocks.

A cost gap approaching two percentage points a year is a huge hurdle for active managers to overcome. "The large-cap market in particular is too efficient for any manager to beat over time, given transaction costs and management fees," says Harold Evensky, a Coral Gables, Fla., money manager who relies heavily on index funds.

Index funds have other pluses. Portfolio turnover is minimal, so they realize few capital gains and thereby spare investors large tax bills until they sell their shares. Index funds are also predictable. You can't foretell how a particular index will perform, but you do know that a properly managed index fund will mirror its index. And you never have to worry about a manager screwing up.

Which brings us back to the mother of all benchmarks, the S&P 500.

LESS THAN THE SUM OF ITS PARTS

Because most funds that invest in U.S. stocks compare their results against those of the S&P, the index has come to represent "the market" to a growing body of investors. Actually, the S&P 500 represents the segment of the market that heavily favors large stocks. And lately, the index has increasingly reflected the fortunes of only a small fraction of the 500 companies. That's because the index is weighted according to each company's total stock-market value, and the very biggest companies in the index are growing far faster than the rest. That is, the top 50 stocks in the S&P recently represented 55% of the index's total value, while the remaining stocks (termed the "forgotten 450" by some) just 45%.

The result of this trend is that the S&P 500 is assuming the characteristics of growth stocks, such as Microsoft, Pfizer and Dell Computer. These companies have well-above-average growth rates and high price-earnings ratios.