stock graph down

Paradise Lost? - S&P 500 Gets Ripped

stock graph down

A recent Money magazine article by mutual fund columnist Jason Zweig ("Is the S&P 500 rigged?") has managed to put a fright into at least a few of the investors who have an estimated $1 trillion in index funds pegged to the broad market benchmark. And given how many people still mistakenly equate index fund investing with only the S&P 500, it's not too surprising that some have interpreted Zweig's article as a knock against passive investing as a long-term strategy. Others have even accused him of sensationalism and causing undue worry among the indexing masses.

To me, nothing could be further from the truth. Although the whole point of investing in a low-cost S&P 500 index fund is to sleep easy with market returns, no investor is well-served by acting like the ostrich. As Larry Swedroe, author of What Wall Street Doesn't Want You to Know, recently told me, "Being a passive investor does not relieve you of the responsibility of estimating returns and looking at market valuations."

Of course, the fact the that the cap-weighted S&P 500 index has become increasingly tilted toward growth and technology stocks is not news for seasoned passive investors, and Swedroe and others have been saying as much on our discussion boards for quite a while now. But Zweig (who calls himself "The Fundamentalist") writes to a more general audience, as he explains in an open letter posted on Morningstar:

"The point of my article was not to suggest that the S&P 500 has somehow become a bad index, but simply to report new developments that investors truly do need to be aware of: The S&P is more actively managed than most investors have realized, and the consequence of that active management is to make it much growthier and techier than it had been . . . Those things constitute important information that investors need to consider . . . As an avid and permanent indexer myself, the new changes do not upset me - but I'm very glad I understand them."

Zweig might take a paternalistic view toward indexers - but he is definitely a practitioner of tough love. Perhaps the most unsettling part of his most recent article for many was the realization that the S&P 500 is not constructed by hard-and-fast objective guidelines, but rather by a seven-person committee.

"Like the admissions committee of an elite country club dropping white or black balls into a wooden box, the Index Committee of Standard & Poor's meets in secret; its proceedings are at least as private as those of the Federal Reserve Board, with no minutes released or memorandums issued," writes Zweig. (For more on the selection process, check out our interview with S&P chief strategist David Blitzer)

There's a funny irony there. The Vanguard 500 fund is the second-largest mutual fund in the U.S., with over $80 trillion in net assets. There are legions of index funds that track the S&P 500. For better or worse, the S&P 500 has become synonymous with indexing. Yet, the scene depicted above by Mr. Zweig smacks of, well, active management. I think he is aware of the dramatic effect of this passage, and I also think it's his direct response to what he perceives as widespread misunderstanding about how the index is maintained.

But regular readers and fans of Zweig's column (I'm one) know that he is a student of human psychology and behavior, particularly when it comes to investing. I was reminded of this recently when I reread a letter exchange we posted last year between Mr. Zweig and editor Jim Wiandt. In the exchange, Zweig was genuinely worried that index fund assets were on the rise because of the strong outperformance of the S&P 500 in the mid and late 1990s - "many index fund investors are doing the right thing for the wrong reason: they are chasing performance, and when it goes away so do they," wrote Zweig. He rightly points out that it's not enough to do the right thing - you need to understand why you're doing it.

What probably frustrates some about the S&P 500 article is that it offers no real solutions. Then again, we too were accused of unwarranted fear-mongering when we posted a recent article that questioned the widely-held mantra of "stocks for the long run."

Ultimately, I welcome Zweig's article and more like it simply because I believe investors can make the best decision only when they have all the information and knowledge at their fingertips. Just remember . . . sometimes the best decision is to do nothing at all.