Updated: May 3, 2013 12:14PM
Originally published: August 7, 2001
The Standard & Poor’s 500 stock index and the Nasdaq 100 have dominated the market completely, until the past week’s decline in the technology and Internet sector. The Dow Jones industrial average pulled ahead - closing the week up 14.3 percent for the year, vs. a gain of 7.3 percent for the S&P 500.
After months of carping that the Dow Jones industrials don’t represent the ``new’’ American economy, the ``old-fashioned’’ Dow stocks are gaining some new advocates. Suddenly, investors are turning their attention to the more traditional cyclical industrial companies such as chemicals (DuPont, Union Carbide), paper (International Paper), machinery (Caterpillar), industrial metals (Alcoa) and even aerospace (Boeing). All these basic industry stocks have started to register gains. And the small-cap companies have started to perk up as well.
Is this the long-awaited sector rotation out of technology - or just a short-term diversion? Only time will tell, although it’s hard to accept the possibility that all the true believers in the Internet would desert that arena and turn their investment dollars to more traditional industries. But a change in investing patterns would affect the S&P 500, which is used as a benchmark by most large-cap equity funds. So it’s worth taking a closer look at the index - and its followers.
The S&P is an index that is weighted by market capitalization.
Thus the larger, better-known companies account for a greater percentage of the gains in the index. The top 13 companies of the S&P 500 stock index account for 25 percent of the value of the index.
Those companies include: Microsoft, General Electric, Merck, Wal-Mart, Pfizer, Exxon, IBM, Coca-Cola, Cisco, MCI-Worldcom, AT&T and AIG. The top 50 companies in the index account for 50 percent of its market value.
As money pours into the largest and best-known companies, it pushes those share prices higher - and disproportionately affects the index itself. As the index rises, it attracts even more investments in funds that replicate the index - funds such as the Vanguard S&P 500 Stock Index Fund. In 1998, 16 percent of all the cash that flowed into equity funds went into the S&P 500 index products, while another 7 percent went into funds indexing other parts of the market.
And the S&P has been a hard benchmark for active managers to exceed. The S&P 500 index beat 87 percent of all the managed equity funds in 1998 - a percentage that is slightly distorted by the fact that many equity funds benchmark smaller market indices. In fact, index funds beat 88 percent of managed equity funds in 1997, and 78 percent in 1996. Fund managers who use the S&P 500 performance as their measuring stick have had to explain to shareholders why they missed the mark. Or else, they’ve become ``closet-indexers’’ - owning the top stocks in the index, which have given the biggest lift to the market.
That explains why all the stocks in the index haven’t advanced proportionally. Gus Sauter, who manages the Vanguard 500 S&P Index Fund, notes that the 50 largest stocks in the index were up more than 30 percent in the 12 months ending March 31. But the smallest 50 companies were actually down 16 percent. It’s a phenomenon he attributes to the money managers who are chasing momentum. Even with the money flowing into funds like his, Sauter points out that index products represent only 8 percent of all equity mutual fund assets.
Some value managers have warned that index fund investors could be in for a shock if the market does decline. Since index funds have a very low portfolio turnover (about 3 percent to 5 percent annually in the Vanguard fund), they theorize that redemptions in a stock market decline could cause big capital gains distributions for the remaining shareholders. After all, the funds have followed a buy-and-hold and then buy-more strategy throughout the stock market’s incredible rise.
But Sauter says that’s absolutely not the case. The Vanguard index funds have a ``HIFO’’ system of selling stocks - ``highest in, first out.’’ That means that if investors started redeeming fund shares during a market decline, the fund would sell the highest-cost (most recently purchased) stocks first. In fact, Sauter’s studies show the market would have to have a 20 percent decline, and it would have to trigger a 38 percent redemption of fund assets - about $26 billion - before the fund began to realize the first penny in capital gains!
So should you stick with your S&P 500 stock index funds, even if the market is focusing on other sectors? Well, that depends on whether you’re a true believer in indexing - or just a trend follower. If you use index funds - for small caps and international stocks, as well as the S&P 500 - to form the basis of your investment portfolio, then you’ve achieved low-cost diversification and reasonable predictability.
If, on the other hand, you’ve been enjoying the ride with a portfolio manger who has turned in outstanding results because he or she is hitching a ride on the big-cap stocks that dominate the S&P 500, you might want to keep a close eye on the index. Those managed funds that concentrate in the top stocks might take a bigger decline than their benchmark. After all, they don’t have the drag of those old-fashioned cyclical stocks in their portfolio to cushion any drop.
Terry Savage is a registered investment adviser for stocks and commodities and is on the board of directors of McDonald’s Corp. and Pennzoil Co. You can send her questions via e-mail at email@example.com. Her second book, published by HarperCollins, is Terry Savage’s New Money Strategies for the ‘90s. Copyright Terry Savage Productions.