Why S&P 500 Leaves Many Funds in the Dust
By GRETCHEN MORGENSON
Why is it so difficult for professional money managers to beat the market these days? And why does it seem to be getting tougher all the time?
These are questions that investors have asked recently, with increasing distress, as they compared returns generated by their mutual funds or money managers with those of the overall market.
And the benchmark that has been so maddeningly unbeatable is the Standard & Poor's 500-stock index, which tracks the performance of 500 of the United States' top companies in the nation's dominant industries. It is run by Standard & Poor's, an investment information services company owned by McGraw Hill Cos.
For the 12 months ended Jan. 31, for example, almost 70 percent of stock mutual funds underperformed the S&P 500. According to Joseph Mezrich, head of the quantitative strategy group at Morgan Stanley Dean Witter, fund performance has deteriorated steadily since 1993, when almost two out of three funds actually beat the index.
One reason for the failure may be simply that the membership of the S&P 500 itself has become a more exclusive club. While other factors are also at work, James Paulsen, chief investment officer of Wells Capital Management in Minneapolis, makes an intriguing case that the S&P 500 may be getting harder to beat for active managers, in large part because of how its makeup has changed in recent years. As the index has transformed itself -- by accident and by design -- it has left many managers behind.
The S&P 500 is the benchmark used by 97 percent of U.S. money managers and pension-plan sponsors. In addition, over $600 billion in investors' money is invested simply to mirror the performance of the S&P 500.
Paulsen's research shows that since 1994 the S&P 500 has become dominated by what he calls new-economy stocks, those in health care, technology, telecommunications, financial services and consumer services companies. While such companies made up roughly 60 percent of the index in 1994, they made up almost three-quarters of it at the end of last year.
At the same time, what Paulsen calls old-economy stocks -- those in energy, transportation, utilities, industrials and basic materials -- make up far less of the index than they did in 1994. Companies in these industries accounted for 16 percent of the index recently, down from almost 30 percent in 1994.
The result, Paulsen says, is a shift in the S&P 500 away from stocks forged in the industrial era and into companies created by the technology revolution. "These trends are due not only to performance differences in recent years but also to a change in the composition of the S&P names," Paulsen said. "Most of the names being eliminated from the index are old-economy names; those being added are new-economy names."
Last year, for instance, S&P made a record 48 changes to the 500 stocks in the index, up from 30 changes in 1997. Additions included technology companies like Gateway, America Online and Compuware, a software maker. Among those deleted from the index were Pennzoil-Quaker State; Safety-Kleen, a transporter of hazardous waste materials, and Charming Shoppes, a women's apparel retailer.
This shift is even more striking when viewed against two sister indexes, the S&P Midcap 400 index and the S&P Smallcap 600 index. According to Paulsen, the share of "new-economy" stocks in the Midcap index is only marginally higher now -- 56 percent -- than in 1994, when it was 51 percent. And the Smallcap index has not increased its exposure to new-age companies at all.
Meanwhile, old-economy stocks have declined somewhat in both indexes, but not nearly as significantly as their drop in the S&P 500. Roughly 26 percent of the Midcap index's value lies in industrial-age stocks, down from 33 percent in 1994. The Smallcap index has 20 percent exposure in these stocks, down from 23 percent in 1994.
"The large-cap indices are moving faster toward the tech revolution," Paulsen said. "Most of our small companies are doing more of the industrial pursuits."
Few investors realize how much indexes change from year to year. Their makeups shift for two reasons: the performance of the stocks that are in an index and the additions and deletions made to the index by its administrators.
It is impossible to know which factor is the bigger contributor to the S&P 500's transformation. Because it is an index weighted by market capitalization of its stocks rather than an equal distribution of companies, rising stocks inherently gain greater weight.
And given that the S&P 500 has had such a tremendous run in recent years -- up 170 percent from the beginning of 1995 to the end of 1998 -- a feedback effect propels more investors into it or the stocks that have been most responsible for its returns.
The Dow Jones industrial average is weighted slightly differently, by the price of each of the 30 companies in it. The more the higher-priced stocks move, the greater the impact on the average. While the Dow had lagged behind for a couple of years, in recent weeks the industrial average has risen faster than the S&P. The Dow is up 13.96 percent for the year vs. the S&P 500's 7.62 percent gain.
Because of its market capitalization weighting, therefore, the S&P is an index that day by day owns more and more of the stock market's stars and fewer of its duds. Recently, while the stars have been few, they have been white-hot.
Leah Modigliani, an equity strategist at Morgan Stanley, points out that just five stocks -- Microsoft, America Online, Citigroup, MCI Worldcom and American International Group -- accounted for 52.7 percent of the performance of the S&P 500 in the first quarter. In all of 1998, 15 stocks accounted for such a performance.
Even more astounding, in the first quarter the top 18 stocks accounted for 100 percent of the S&P's 5 percent rise. That means the remaining 482 stocks added nothing to the index's return. Sixty percent of the stocks in the 500 underperformed the index's 5 percent return in the first quarter, while 55 percent lost ground in the period.
But performance is not the only thing that changes an index. These indexes are managed actively by their administrators. Companies are dropped from the S&P 500, for example, as they are acquired, if they encounter financial problems or when the Standard & Poor's index committee decides that they are no longer representative of the overall stock market.
This committee of nine decides which companies are to replace those that are removed. They are much more likely to add a hot company to the index than one that has been cold of late.
"There's also a certain amount of momentum associated with companies going into the 500," said Elliot Shurgin, vice president for index products and services at Standard & Poor's. "Typically we'll look at the universe of companies not in the 500 and rank them in terms of size. What tends to happen is companies going through rapid growth phases become large enough in terms of market cap -- assuming they satisfy liquidity requirements -- to get into the index."
The divergence of new economy and old in the S&P 500 may be another way of explaining why fund managers who focus on value have done so poorly in recent years. As valuations of technology, financial services and health-care stocks have been driven well into the stratosphere, value stocks are more likely to be rooted in the old economy, bricks and mortar and all.
"The individual investor is out there buying recognizable names," Paulsen said. "In essence he is going toward the new-economy winners faster than a manager might."
As value stocks lag, of course, their market capitalizations dwindle. This has its own feedback effect, making them less attractive to institutional investors who require ease in entering and exiting stocks in large trades.
Mezrich of Morgan Stanley has his own theory to explain why money managers find it nearly impossible to beat the S&P 500.
It has two elements: Money managers do not typically weight their holdings based on market capitalization, as an index does, and therefore are unable to mirror the index's performance; and even large-capitalization fund managers are likely to have larger holdings of slightly smaller-capitalization stocks than the S&P index holds. This means that even those managers who have been investing in large-company stocks recently have been tarred by the investor bias against smaller companies.
"If you're an active manager, you're going to pick stocks that are smaller than the average capitalization in the index," Mezrich said. "And if you own them in an equal weighting relative to the S&P, you would have a small-cap bias."
Given all this, it is no surprise that investors are dumping their managers in droves and retreating to automatic pilot -- funds that mimic the returns of a big-capitalization stock index. In the first quarter of 1999, according to AMG Data Services, 73 percent of the $24 billion that Americans put into equity mutual funds flowed into index funds.
Of course, the S&P 500's broad outperformance of money managers will not last forever. And in recent days, leaders in the index, stocks such as General Electric, Citigroup, Pfizer and America Online have grown weak while old-industry stocks such as Caterpillar, Alcoa, and Minnesota Mining and Manufacturing have rallied. Still, it might take quite a market jolt to move fund managers ahead of the index again.
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