Is time running out for the S&P 500?

The S&P 500 has defined the U.S. stock market for decades. But more and more institutional investors are swearing off the index, saying it distorts the very market it purports to represent. Academics agree. Is it time for a new benchmark?

The S&P 500 has defined the U.S. stock market for decades. But more and more institutional investors are swearing off the index, saying it distorts the very market it purports to represent. Academics agree. Is it time for a new benchmark?

By Rich Blake
May 2002

In 1961 William Sharpe sat deep in the recesses of the UCLA library amid reams of papers bearing arcane formulas. Working on a revolutionary new theory of the stock market, the 26-year-old doctoral candidate needed a proxy for the stock market for his research. So he turned to an obscure statistical index introduced a few years before by the venerable rating agency Standard & Poor’s: the S&P 500.

Sharpe would go on to develop the capital asset pricing model, a cornerstone of modern portfolio theory. This seminal but still hotly debated doctrine holds that ultimately the stock market is efficient: Share prices embody everything that investors know about stocks. Therefore, Sharpe posited, the only way investors could beat the market long term was to take greater-than-market risks.

Several years earlier Harry Markowitz had pursued a similar line of inquiry while working toward his Ph.D. at the University of Chicago. In 1959 Markowitz published Portfolio Selection: Efficient Diversification of Investments, which delved, densely, into the risk-return dynamics of portfolio diversification (see box, page 62).

Together Sharpe and Markowitz, who shared with the late Merton Miller the 1990 Nobel Prize for economics for their pioneering studies of market behavior, laid the foundation for a whole new industry: passive investing. Today $1.4 trillion is invested in U.S. index funds, which for the most part mimic the S&P 500. That’s roughly one out of every ten investment dollars; 20 years ago the figure was one out of every 100.


But the impact of the S&P 500 wasn’t confined to passive investors. Active managers also grew used to having their performance measured , benchmarked , against the S&P 500. By the mid-1990s, during the greatest bull market in American history, more than half of all dollars invested in U.S. stocks by money managers were pegged, either actively or passively, to the S&P 500. In the minds of many investment professionals, the S&P 500 wasn’t just a symbol of the market , it was the market itself.

So what does Sharpe think of the index today?

“The S&P 500 is not the best benchmark available,” the Nobelist declares. “Back in the early 1960s it was, but not anymore.” What is the best benchmark? “If you’re going to have a benchmark for the market, it should be the Wilshire 5000,” asserts Sharpe. “The S&P 500 is only 80 percent of the market.”

His co-Nobelist, Markowitz, puts it even more emphatically. The S&P 500, he says, “is a goner.”

Sharpe, 67, and Markowitz, 74, remain in the vanguard of financial thinking, but they’re hardly alone among market theorists in their disenchantment with the S&P 500. Wharton School finance professor Jeremy Siegel, an early and avid proponent of passive investing, now says: “I championed S&P 500 indexing and believe I was right in doing so. But you might find that indexing to the S&P going forward underperforms as a result of the artificial pop in the stocks that comprise the index.”

Money manager Rex Sinquefield and Yale University finance professor Roger Ibbotson produced, in 1974, the first complete set of historical data tracking the returns of stocks, bonds and Treasury bills since 1926. Stocks stood out, thus helping to popularize the S&P 500. What does Sinquefield, chief investment officer of Santa Monica, California,based Dimensional Fund Advisors, think of the index today? “The S&P 500’s best days are probably behind it,” he says. “It’s just not the only game in town anymore.”

Plenty of investment practitioners also consider the S&P suspect. And although they may not be contemplating monographs on the subject, they do determine which benchmark to employ. According to Chicago-based pension consulting firm CRA RogersCasey, since 1999 one third of the roughly 300 major pension plans it follows have stopped using the S&P 500 as a benchmark. The firm estimates that the proportion of active managers that pit themselves against the S&P 500 slipped from nearly 100 percent in 1980 to 70 percent in 2001.

“Use of the S&P to measure equity portfolios has been steadily decreasing among large plan sponsors,” says Paul Schaeffer, director of investment management research for CRA RogersCasey. “Now the trend has started to accelerate. People are realizing that with the S&P 500 you are getting more of a large-cap growth measure than the total market.”

What’s the matter with the S&P 500 anyway? Its flaws are both inherent and practical. For a start this “market” benchmark doesn’t encompass the broad market: Some 5,500 stocks representing $1.7 trillion in market capitalization are left out in the cold. Moreover, Standard & Poor’s selection criteria (“leading companies in leading industries”) have skewed the index so far toward large-cap growth stocks that to many it’s really more of a “style” index.

The S&P 500’s besetting sin, though, may be that it simply became too popular. So much money is now indexed to the S&P, either formally by passive managers or informally by active managers shadowing the benchmark, that it has become grossly distorted by concentration, warping the market it’s meant to mirror.

Andrew Lo, head of the Massachusetts Institute of Technology financial engineering program, contends that the S&P 500 “has become so visible and attracted so much focus that it puts a lot of stress on stocks in the S&P,” distorting both those stocks and the wider market.

In bull markets a handful of big stocks utterly dominate the 500, forcing passive and active investors alike to channel more and more money into those companies to keep up with the index, creating a vicious cycle as the chosen shares, and thus the index itself, rise ever higher. In the prebubble days, investors poured ever more money into such star stocks, which pushed them higher, compelling investors to pump still more money into them. And so on and so on. Merely being included in the red-hot S&P (up 29 percent in 1998 and a further 21 percent in 1999) gave stocks a boost , that artificial pop Siegel refers to.

Indeed, some speculate that money managers’ obsession with trying to keep pace with the super-charged S&P 500 got to the point that the index became a contributing factor to the bubble. “Probably the worst thing that has gone on in the stock market is the amount of managers who in the late 1990s weighted their portfolios to match the 30 largest stocks in the S&P,” says legendary Legg Mason portfolio manager Bill Miller. “It’s a poor way to manage money, and you could argue it helped contribute to the bubble.”

“Did money managers become overly obsessed with the S&P 500?” asks Brian Bruce, global investment chief at Panagora Asset Management in Boston. “Of course, it’s how we were judged.”

Not everyone agrees, of course. “There was no Tulip 500 index,” scoffs Gerry Rocchi, CEO of Barclays Global Investors Canada, dismissing the notion that the S&P 500 indexing phenomenon had anything to do with causing the ‘90s bubble. “Manias don’t need benchmarks to thrive.”

Another frequent criticism: that Standard & Poor’s, which is estimated to collect some $80 million per year in licensing fees from its indexes, adjusts the S&P 500 as much to keep the aging index vital as for any theoretical reasons. Keeping on top of market trends, the confidential committee that determines which stocks make up the S&P roster shucked rust-encrusted conventional manufacturers and pursued giddy tech stocks with a vengeance to lend the index a New Economy gloss. Indeed, to a number of critics, a fundamental defect of the S&P 500 is that it doesn’t purport to be an intellectually rigorous, objective correlative of the market. First and foremost the index is a commercial product, so it invariably caters to some degree to popular demand, which in the late 1990s was avid for anything labeled tech.

Standard & Poor’s disagrees. “We are not choosing stocks we think will go up,” insists S&P chief investment strategist David Blitzer, who chairs the company’s index committee. “The index is 500 stocks chosen to reflect the markets, and through the markets, the U.S. economy.” So when growth stocks dominate the market, he says, they also dominate the S&P 500.

Plainly contentious, the ongoing debate about the S&P 500 could have significant implications, leading at one extreme to a profound reorientation of investment thinking. Professional money managers would lose their reflexive attachment to the index, just as their predecessors abandoned the Dow Jones industrial average to the retail masses and TV anchors for the S&P 500.

Such a loss of icon status, or mind share, would be a boon for rival indexes, like the Wilshire 5000 and the Russell 3000. And it would, at the least, take a bite out of the pocketbooks of the shareholders of McGraw-Hill Cos., which owns Standard & Poor’s. But it might also make for a healthier market, one in which a fixation on an all-powerful S&P index wouldn’t drive most investment decisions and market bubbles wouldn’t get the chance to become so dangerously inflated.

Critics gripe that the S&P 500 is a broad , but not broad enough , market index when the more meaningful benchmarks in this age of portfolio specialization are style-specific indexes (value or growth, small-cap or midcap); that it is in reality not a market index at all but a large-cap growth index; and that the selection of fresh stocks to replace those being dropped from the index inflates the newcomers’ value.

Behind all these cavils, S&P defenders counter, is really just one long-festering complaint: Active managers find the S&P dauntingly tough to outdo consistently , as Sharpe could have told them. Morningstar reports that fewer than half of the 336 U.S. equity funds it monitors beat the S&P 500 over the five years through March (not counting fees, of course). Going back ten years, only one fourth beat the S&P 500. S&P chief investment strategist Blitzer observes correctly if not disinterestedly, “Remember that a lot of dissatisfaction with the S&P 500 comes from money managers who have a hard time beating it.”

But every day the ranks of S&P 500 skeptics seem to swell. Like Sharpe, academic critics of the index note that S&P 500 stocks represent only four fifths (78 percent, to be precise) of the U.S. stock market’s total capitalization. Thus, trailing the S&P 500 doesn’t necessarily mean lagging the “market” at all , and vice versa. While the S&P 500 declined 11.9 percent last year, fully two thirds of the stocks in the index did better than that , and 43 percent were actually in positive territory. Of stocks overall, as reflected by the Wilshire 5000 (which actually contains 5,912 stocks), 50 percent rose last year. The S&P 500 can be equally misleading when times are good. In 1999 the index rose 21 percent, but 49 percent of S&P 500 stocks actually declined.

But this sort of skewed performance by the S&P 500 only hints at the underlying distortion. The S&P’s influence is so pervasive that most active professional investors believe that they must try to keep up with it , stalking the S&P, as it were , so they funnel money into the index’s dominant names on the theory that this way they can at least capture the bulk of the S&P’s gains. Because the index is weighted by market capitalization, this strategy further serves to transform a relative handful of stocks into all-powerful arbiters of the S&P’s performance.

“The S&P 500 turned into a monster because it became overused,” says Craig Israelson, a finance professor at the University of Missouri and a monthly mutual fund columnist for Financial Planning magazine. “The biggest stocks kept getting bigger in a self-perpetuating cycle.” Microsoft Corp., for example, went from 1 percent of the index’s market cap when it joined the S&P 500 in 1994 to 4.4 percent by late 1999; during that same period, Intel Corp. jumped from less than 1 percent to 2.3 percent and Cisco Systems went from 0.2 percent to 2.9 percent.

In a working paper released in December, the National Bureau of Economic Research makes the case that increased demand for S&P 500 stocks has artificially pushed up their prices and thus “may have had the perverse effect of undermining the efficiency of the stock market.” The study used the familiar Q score created by the late Nobel Prize winning economist James Tobin (basically, the Q score measures the market value of a company’s assets divided by their replacement value) to assess how much of a halo effect the S&P actually bestows.

In 1978, the NBER found, the average Q ratio for S&P companies was 0.8, while that of similar companies outside the index was 0.7. A modest effect. In 1997, however, with the stock market booming, the gap was far wider: Q scores for S&P companies averaged 2.3, whereas those for comparable non-S&P firms averaged 1.7.

When stocks rise or fall based on whether or not they’re included in the index, the natural pricing process becomes corrupted, maintains University of Alberta finance professor Randall Morck, a co-author of the NBER study. “Put simply,” he contends, “the S&P is screwing up the pricing of the market. The market is probably not as efficient as proponents believe; otherwise you wouldn’t see this kind of premium for companies in the S&P when the fundamentals don’t seem to justify it.”

Market pricing is working just dandy, counters Princeton University economics professor Burton Malkiel, author of the 1973 classic, A Random Walk Down Wall Street. Using data from 1993 and 1998, he studied a random sample of approximately half of the companies in the S&P 500 and discovered that earnings multiples for S&P 500 stocks were actually a point lower than those of a comparable universe of non-S&P 500 stocks. “The flow of funds into the S&P 500 has no identifiable effect on the excess return of the S&P 500 over actively managed funds,” concluded Malkiel in a January 2001 article in the Journal of Portfolio Management. “This suggests that the success of indexing has not been a self-fulfilling prophecy.”

Perhaps not, but it’s hard to dispute that the S&P 500 today suffers from a dangerous level of concentration: At the start of this year, the top 25 stocks, or just 5 percent by number, accounted for fully 41 percent of the index by capitalization , and thus greatly influence the S&P 500’s performance. The proportion today is close to its June 2000 peak of 44 percent and compares with the 34 percent average that prevailed throughout most of the 1980s and ‘90s (see top graph, page 54).

Of course, as the index grows more concentrated, it becomes less diversified and hence inherently riskier: Investors in the S&P 500 are today putting most of their eggs in a few big baskets. “You take on greater stock-specific risks as opposed to market risk,” points out Vanguard Group’s chief of equities, Gus Sauter, who manages the Vanguard Index Trust , 500 Portfolio, an S&P 500 index fund.

“Scenarios in which fewer and fewer names account for an increasing percentage of the S&P 500 can have negative conseconsequences,” warns Steve Galbraith, chief investment strategist for Morgan Stanley. “Blowups are costing more. Owning the 20 worst-performing stocks in the S&P has historically cost investors around 110 basis points, but more recently, the cost has been close to 300 basis points. In a business where over time a few hundred basis points separates the megastars from the has-beens, playing defense should be of more than academic interest to fund managers and clients.”

Concentration can indeed exert a powerful undertow effect. Just five outsize stocks , Cisco, EMC Corp., Merck & Co., Nortel Networks Corp. and Oracle Corp. , were responsible for almost one third of the S&P 500’s 9.1 percent loss in 2000, calculates Thomas Doerflinger, senior investment strategist at UBS Warburg. Adds Morgan Stanley’s Galbraith, “Somehow, investing in the S&P 500 became viewed as a risk-free way of investing in the stock market, and that’s hardly the case.”

Economist Peter Bernstein, whose highly respected 1996 book, Against the Gods, explores market risk, notes, “Indexing always adds risk because it reflects the bloat in capitalization of market leaders.”

The more that the S&P 500 came to be defined in the late ‘90s by just a few names, the more the index lurched down as well as up. “With the stakes that high , we are talking about trillions of dollars riding on far-out assumptions , even the slightest dampening of the ultrarosy outlook could cause wild swings,” says James Floyd, senior analyst at Leuthold/Weeden Research, an equity research firm in Minneapolis. “That’s the reason we saw such high volatility. It got pretty severe.” In 2001 the S&P 500 registered swings of 1 percent or more on 105 of 249 trading days, or 42 percent of the time , twice the historical rate.

Nonetheless, the S&P was not significantly more volatile than other market indexes. “The concentration in the S&P 500 certainly added to market volatility, because ‘the market’ was less diversified than it had been,” Bernstein says. But “this phenomenon would have been reflected in the Wilshire, too, although less dramatically.”

Mellon Capital CEO Thomas Loeb, who back in 1971 at Wells Fargo Bank managed the very first S&P 500 index fund, says, “People got so magnetized by the S&P 500 that it became hard to do the right thing” in terms of focusing on clients’ best long-term interests rather than going through contortions to avoid trailing the S&P 500. His first choice for a broad market index these days: the Russell 3000.

Pension adviser Grantham, Mayo, Van Otterloo & Co. has been encouraging its active management clients to switch from the S&P 500 to the Wilshire 5000 for five years. “You use an index because you want a proxy for the U.S. market. The Wilshire 5000 is the U.S. market. The S&P is a subset of the market,” explains Ben Inker, director of asset allocation. Of course, as he concedes, keeping up with the market is not such a splendid achievement when the market happens to be in free fall. “A client will say, ‘You haven’t done me any favors!’” sighs Inker.

The S&P’s rival benchmark purveyors, Wilshire and Russell, are attracting an ever-greater share of the $1.25 trillion market for U.S. equity index funds. They say that roughly $250 billion in index funds is now pegged to their various indexes, up from essentially nothing five years ago. The Russell 3000 alone has amassed $95 billion, a record high for that index. Early this month the California State Teachers’ Retirement System, the third-largest U.S. pension plan, ditched the S&P 500 as its benchmark, replacing it with the Russell 3000.

To be sure, the sundry Wilshire and Russell indexes are still dwarfed by the S&P, which boasts $1 trillion in indexed funds. That is down considerably, however, from a peak of $1.25 trillion at the end of 2000, in part, of course, because the market itself has lost so much value. The flow of money into S&P 500 index mutual funds also fell, from $24 billion in 1999 to $5 billion last year, although much of this reflects retail investors’ disenchantment with stocks in general. Still, assets passively invested in the Russell indexes has increased from $116 billion at the end of 1999 to $214 billion in 2001.

The battle between rival indexes is moving to new terrain as exchange-traded fund investing explodes , some $88 billion in assets were invested in the indexlike securities as of last month. Two products modeled after the S&P 500 have drawn $32 billion in ETF assets. ETFs linked to the Nasdaq 100 claim $22 billion, while ETFs linked to the Russell 3000 and Wilshire 5000 have a combined $3 billion.

Urged on by money managers, more and more consultants and plan sponsors are using style-specific indexes to keep tabs on specialized managers’ returns relative to their cohorts while relying on truly broad market indexes, like the Wilshire 5000 or a global index , to assay the performance of a plan sponsor’s multiple managers in toto.

“There is no perfect benchmark, but the S&P has clearly lost ground as the equity benchmark of choice,” says Louis Finney, a senior consultant at William M. Mercer Investment Consulting. “Plan sponsors are moving to style-specific benchmarks to measure individual active managers and to broader benchmarks to measure their portfolio in aggregate, so the S&P 500 doesn’t really fit in anywhere.”

“Nowadays,” notes Craig Husting, chief investment officer of the $22 billion Public School Retirement System of Missouri, “most plan sponsors will tell you that the Russell indexes are more important to them than the S&P 500. That just wasn’t the case five years ago.” Every one of Missouri’s more than 15 money managers has switched from the S&P 500 to a specialty Russell benchmark over the past three years.

The appeal of style-specific indexes is obvious: They give everyone concerned a better fix on how portfolio managers are doing vis-à-vis their true peers at a time when most managers specialize, if only insofar as they emphasize growth stocks, say, instead of value stocks.

In assessing a growth manager’s 5 percent return in the 12 months through March, which is more revealing? Comparing those results against the roughly 2 percent rise of the S&P 500 or the almost 8 percent gain of the S&P/Barra growth index? A small-cap manager’s 15 percent spurt over the same period might look dazzling next to the S&P 500’s anemic showing, but not when compared with the 20 percent-plus returns of typical small-cap funds. Who does , and doesn’t , deserve a bonus? Starting next month, Morningstar is changing its “star” rating system from one that compares all stock funds against one another to one that recognizes a fund’s performance relative to its peer group. In essence, Morningstar is adopting style benchmarks. Many mutual fund boards, meanwhile, are grappling with whether to change the official benchmarks listed in their prospectuses from the S&P 500 to style-specific indexes, says a mutual fund board member who asked not to be indentifed. “The concern is that people just aren’t as familiar with the Russell 1000 growth or value indexes as they are with the S&P,” he says. “It’s a real tricky issue.”

The S&P 500 can appear to be neither fish nor fowl: too broad to be style-specific, yet not broad enough to be a proper proxy for the market. Standard & Poor’s has implicitly acknowledged this dilemma by introducing its own style-specific benchmarks: the S&P MidCap 400 and the S&P SmallCap 600, as well as a benchmark meant to capture more of the broad market than the S&P 500, the S&P Super Composite 1500, which combines the S&P 500, the S&P MidCap 400 and the S&P SmallCap 600, covering 87 percent of total market capitalization.

Paradoxically, some now view the S&P 500 as itself something of a style-specific index of large-cap growth. Debunkers of the notion that the S&P 500 qualifies in any shape or form as a “market” index point out that although its mandate from the outset was “to represent a broad cross section of the U.S. stock market,” the S&P’s gatekeepers have favored very large companies over small ones (see box, page 58). This comports with the S&P 500’s commandment to include leading companies in the leading industries, but it produces a decided large-cap bias.

Although Standard & Poor’s guidelines suggest that companies should have at least a $4 billion market cap to be included in the S&P 500, no minimum requirement exists. Nevertheless, the index’s stocks currently have an average market cap of $21 billion, compared with just $2.1 billion for the average stock.

Elliott Shurgin, general manager of Standard & Poor’s index services and a member of the seven-person index committee in charge of booting companies out of the S&P 500 club and inviting others to join, makes no bones about the size issue: “I don’t know that we could profess that we are the broad market index. The S&P 500 is a large-cap proxy.”

And what’s wrong with bigness anyway? After all, most institutional investors are themselves biased toward large stocks, partly out of concern for liquidity and partly, no doubt, out of sheer habit. Fortunately for them, large-cap stocks overwhelmingly outperformed their smaller brethren in the late 1990s. Big caps, however, have seriously lagged behind small caps since April 1999. Standard & Poor’s own S&P SmallCap 600, for instance, was up almost 27 percent for the 12 months through March.

Many market strategists and economists, including Wharton’s Siegel, suspect that in the normal cycle of things, small caps will go on to outperform large caps for the next few years, as they did convincingly from November 1990 to February 1994. “An investor might do better tilting to the Wilshire 4500 [the Wilshire 5000 minus the S&P 500],” Siegel advises.

Assuming the small-cap scenario plays out , hardly a sure thing , both the Wilshire 5000 (average market cap: $2.1 billion) and the Russell 3000 (average market cap: $4 billion) ostensibly would have a bit of an edge over the S&P 500, since they embrace many more small stocks. Fully 12 percent of Wilshire 5000 stocks have market caps under $2 billion. The Wilshire 5000 did somewhat better than the S&P 500 during the small caps’ rise in the early 1990s, producing an 81 percent cumulative return, versus the S&P’s 71 percent. But to derive the full benefit of a small-cap revival, an investor would need to focus strictly on small stocks. Hence the S&P 500 isn’t at all that much of a disadvantage vis-à-vis competing broad indexes (see graph below).

Even the S&P’s severest critics are mostly reconciled to the index’s large-cap identity. What disturbs them much more is that , they charge , Standard & Poor’s index committee chases after the fastest-growing stocks, excluding middling performers that not only better reflect the broader market but also may be less volatile and possess better fundamentals.

The committee, which in its own way is almost as influential as the Federal Reserve Board’s Open Market Committee and equally secretive, keeps an understandably low profile. Standard & Poor’s won’t disclose the seven members’ names, but they include Blitzer, statistician Shurgin and the managing director of the company’s investment analysis division, James Branscome, longtime director of research at S&P.

The group meets at least once a month, effectively steering a portfolio worth trillions of dollars. To gain admission to the S&P 500, a stock must be approved by all seven committee members. Over the years, the committee has developed rough rules for inclusion: A stock must be liquid, with at least 50 percent of the shares in public hands, and a wanna-be company must show four straight quarters of operating income. Luckily, that kept most of the Internet riffraff out of the index in 1998 and 1999.

Ah, but exceptions can always be made; which explains how money-losing fiber-optics equipment maker JDS Uniphase Corp. was able to join the roster of the 500 in July 2000, when it was trading for $135; recently it was hovering at about $7.

Of course, for every company added, one must be subtracted. Some expulsions are straightforward , the result of mergers or bankruptcies (Enron Corp., for instance) , but committee members have considerable leeway to banish to the hinterlands S&P companies in seemingly good standing and to name successors for reasons that can seem obscure.

“We ask ourselves, If the index were created today, would this company be included?” says Blitzer. “If the answer is no, then we would have to consider removing it.”

Nevertheless, the committee often invokes an ambiguous catchphrase , “lack of representation” , to justify dismissing a company, and the term gained great currency toward the end of the ‘90s. Between 1990 and 1992 just two companies were removed because of lack of representation; in 1996 it was nine companies; and by 2000 there were 19 of these misfits.

Detractors view the committee’s increasing resort to the lack-of-representation blackball as an indication that Standard & Poor’s was desperate to revamp the stodgy old S&P 500 and hardwire it to the tech-dominated New Economy. They point to the unprecedented number of index comings and goings , 90 in all , in 1998 and 1999, only half of them necessitated by mergers. Many (though not all) of the arrivistes were high-flying growth stocks.

“The folks at S&P had to add all of those so-called New Economy stocks,” says John Cuthbertson, a senior analyst at Freeman Associates, a Rancho Santa Fe, California,based investment manager. “Otherwise the index would have become irrelevant.” Standard & Poor’s Shurgin says simply, “In the mid-1990s we were probably underweight technology, so we did try to boost that sector in the late ‘90s.”

But some critics allege that Standard & Poor’s attempted more than an overdue rebalancing: The committee lunged at momentum stocks to try to keep up with the sizzling Nasdaq. “My sense is they were truly trying to reflect what was going in the economy,” says a person familiar with the S&P’s inner circle. “But the problem is that they are a reactionary group , in many ways like the typical investor chasing after the big thing , a day late and a dollar short.”

Aronson + Partners calculated that the stocks added to the S&P 500 between 1998 and 2000 had a median return of 46 percent for the 12 months before their induction (see bottom graph, page 54). The median return of deleted stocks: ,27 percent.

Freeman’s Cuthbertson, meanwhile, found that between late 1998 and early 2000, the S&P 500 enrolled a large number of momentum stocks, including Qualcom, Xilinx and Yahoo!. They provided a kick all right , Qualcom, for instance, rose a staggering 2,617 percent during 1999 , but the addition of these and other hot stocks also boosted the S&P 500’s volatility, Cuthbertson says. The index’s standard deviation rose from 14.2 percent to 14.8 percent during this period. And for the 12 months ended March 31, 2002, the index’s standard deviation was even higher, at 15.97 percent (see table, page 60).

Overall, the current evidence points to a bias, albeit a slight one, toward growth over value. An analysis by consultants at Frank Russell Co. (sponsor of the Russell indexes) purports to show that at the start of this year, long after growth stocks had lost their glow, they still comprised 34 percent of the S&P 500 and value stocks 29 percent. (Russell categorized the remaining 37 percent of stocks as neither.) The growth components of the Wilshire 5000 and Russell 3000 were comparable, at 33 percent and 32 percent, respectively.

Advocates of broader market indexes such as the Wilshire 5000 and the Russell 3000 assert that they could replace the S&P without missing a trade. They argue that both are cap weighted, like the S&P, but make more broadly based, and thus better, surrogates for the market as a whole. This also means their returns are less riskily dominated by the top 25 stocks, say proponents. In contrast to a 41 percent share for the S&P 500, the top 25 stocks represent 35 percent of the Russell 3000’s total capitalization and 33 percent of the Wilshire 5000’s.

Supporters of the S&P 500 retort that this is all fine and well, but as a practical matter, neither of these indexes has the deep liquidity that indexers in particular need to ply their trades. The mean cap of the S&P 500, after all, is ten times that of the Wilshire 5000. Says Blitzer: “The S&P 500 is the only index that provides enough liquidity to truly run an index strategy.”

A few others tout a completely different style of index. “We have seen this play out again and again: The big caps outperform, the S&P gets concentrated, those stocks get way ahead of themselves, and eventually it breaks,” laments Dick Charlton, founder of New England Pension Consultants. “The problem is cap weighting , and the time is long overdue to consider equal-weighted indexes.” Last year, Charlton notes, an equal-weighted version of the S&P 500 fell only 3 percent, compared with the cap-weighted version’s nearly 12 percent decline. Since 1958, in fact, the equal-weighted S&P 500 outperformed its cap-weighted counterpart 60 percent of the time, reports Leuthold/Weeden Research. On the other hand, equal-weighted indexes lagged dramatically in the late 1990s.

For would-be indexers, a significant catch to equal-weighted indexes is that they require daily rebalancing, an unwieldy and expensive process that essentially rules out their use. One of the few equal-weighted indexes around, the Value Line arithmetic index of 1,600 stocks, is consulted chiefly as a performance yardstick. And cap weighting, whatever its limitations, still offers the most accurate portrait of the market: The smallest stock in the S&P 500, US Air Group (market cap: $439 million), simply does not deserve to be accorded the same status as the largest, General Electric Co. (market cap: $372 billion).

The Wilshire and Russell benchmarks will continue to gain on their older rival. The S&P will survive, of course, partly for the same reason that Americans stubbornly persist in measuring things in yards and quarts, not meters and liters. But it will be hard-pressed to recapture the heights it commanded for more than 30 years. Tellingly, since July 2000 Fed chairman Alan Greenspan has referred to the Wilshire 5000 as his market proxy in each of his biannual reports to Congress. Before then, Fed chairmen had cited only the S&P 500.

From the man who brought indexing to the masses comes this rumination: “To be on the safe side,” says Vanguard Group founder Jack Bogle, “I would tell someone who is considering indexing to invest in the Wilshire 5000. But I wouldn’t waste my breath trying to get anyone to switch.”

Too late, Jack, they already are.

The rise of the S&P 500

Why do so many professional investors persist in measuring their performance against the Standard & Poor’s 500 when other indexes, such as the Wilshire 5000 and Russell 3000, are broader based and thus potentially better proxies for the market as a whole? History, so venerated on conservative Wall Street, has a lot to with the S&P’s enduring popularity.

The Dow Jones industrial average has been around since 1896. But from its debut on March 4, 1957, until the introduction of the rival Wilshire 5000 in 1974, the S&P 500 was the sole stand-in for all U.S. stocks, the one truly broad-gauged market index. That monopoly, backed up by canny marketing, gave the S&P such a head start that neither the Wilshire 5000 nor the Russell 3000 was able to make real inroads with money managers , either as passive investment vehicles or as benchmarks , until relatively recently (story).

Standard & Poor’s, the parent of the S&P 500, has occupied a central place in U.S. financial history for far longer than its eponymous index. At the end of the Civil War, the editor of the American Railroad Journal, Henry Varnum Poor, launched a publishing business in New York and in 1867 came out with research on the dot-coms of the day: Poor’s Manual of the Railroads of the United States. At 442 pages, it sold for a then princely $5. More manuals followed, and his enterprise flourished.

Forty years later, in 1906, a 32-year-old former telegraph operator from Tennessee named Luthur Lee Blake founded the Standard Statistics Bureau in a spare room at the Calumet Hotel near Wall Street to sell basic financial information about companies to banks and brokerage houses; they paid $5 a month for stacks of index cards bearing data.

To compete with the Dow, Blake’s firm introduced a broader market index consisting of 233 stocks in 1923; five years later Standard Statistics came out with daily indexes for 90 stocks that Blake considered a fair sample of the market. He divided the index into three components: a 50-stock industrial index, a 20-stock railroad index and a 20-stock utility index. By 1941 the broader index had grown to 416 stocks.

That same year, Standard Statistics merged with Poor’s company and was incorporated as Standard & Poor’s. In the early 1950s the firm began promoting its 90-stock index to reporters as a better market barometer than the Dow. The index began to have a public currency and gained official recognition in 1955, when several government agencies, including the Securities and Exchange Commission, started using it.

It wasn’t until the late 1950s, however, that innovations in computer technology made it possible for S&P to calculate its broader market index , by this time grown to 500 stocks , on a minute-by-minute basis. On March 4, 1957, the company introduced the S&P 500 composite stock price index. During the early 1960s money managers kept an eye cocked toward the S&P 500, as the index was dubbed, but they had little inclination to treat it as a benchmark. Recalls legendary value investor John Neff, “You just picked stocks and hoped you did better than the other guy.”

But as the ‘60s got go-going, the industry’s hottest money managers took to plugging their stock-picking prowess by comparing their performance with the S&P 500’s, raising the profile of the index. Fred Alger, who had launched Alger Management in 1964, became one of the first to refer to the S&P 500 as a benchmark. “Guys like me and Jerry Tsai were pushing the concept of aggressive portfolio management,” Alger recalls. “To justify our performance fee, we measured ourselves against the S&P 500. We promised to do better.” Michael Jensen, a Harvard Business School finance-professor-turned-industry-consultant, found that most managers did not beat the S&P 500 , giving the index added juice.

In the late 1960s Neff approached his boss, Jack Bogle, then CEO of Wellington Management, about introducing an incentive-based pay scheme linked to the S&P for him and his peers. Beat the index, and you would be rewarded for it, and vice versa.

The 1969,'70 minibear market thrust the index to the forefront. Its 8.6 percent drop, peak to trough, sparked interest in emerging efficient-market theories. Says William Sharpe, who with Harry Markowitz pioneered modern portfolio theory, “It took a while for the investment community to accept what I had been saying all along , that you couldn’t beat the market.”

So-called passive investing in stock market indexes was what more than anything else would solidify the power of the S&P 500. In 1970 a team at California’s Wells Fargo Bank, collaborating with leading academics like Fischer Black and Myron Scholes of derivatives fame, produced America’s first index fund: an equal-weighted compendium of 1,000 stocks traded on the New York Stock Exchange. It debuted on July 1, 1971, seeded with $6 million from Samsonite Corp.'s pension fund.

The logistical drawbacks of an equal-weighted index became obvious from day one. It had to be rebalanced every day. The S&P 500, on the other hand, didn’t have to be artificially rebalanced because, as a capitalization-weighted index, it effectively rebalanced itself; the more money that investors poured into a particular stock compared with other S&P stocks, the more prominent that stock became in the index, automatically. “Equal weighting was a nightmare,” confides Mellon Capital chairman emeritus William Fouse, who in 1971 was a financial analyst at Wells and helped design the index fund.

Nonetheless, the bank introduced a version of the same equal-weighted index product for institutional investors the following year. In 1976, however, Wells decided that the S&P 500 would be easier all around and switched. American National Bank in Chicago and Batterymarch Financial Management in Boston joined Wells in creating and selling S&P index products for pension funds. Investment consulting firm A.G. Becker started to include S&P 500 returns along with its proprietary performance data.

Still, the investment industry was only dabbling in indexing. In 1975 less than $100 million was passively invested, or about 0.1 percent of the market. The index was to receive a big boost as the definitive equity benchmark in 1974, when Yale University finance professor Roger Ibbotson and money manager Rex Sinquefield released their landmark study, “Stocks, Bonds, Bills and Inflation,” which offered the first set of historical data on comparative returns. Stocks , as represented by the S&P 500 , stood out. From 1926 to 1975 the index (simulated pre-1957) returned about 9 percent a year on average, nearly three times as much as the next-best-performing asset class, 30-year Treasury bonds. “The study gave the index an infinite boost,” says Sinquefield. S&P chief investment strategist David Blitzer agrees. “It helped put the index on the map,” he says.

The year 1974 also saw the emergence of the S&P 500’s first rival as a broad market index: the Wilshire 5000. The creation of Wilshire Associates founder and CEO Dennis Tito, a former NASA engineer (and 27 years later a pay-as-you-go cosmonaut), the index encompassed a universe of stocks ignored by the S&P 500. In January 1975 Barron’s began publishing the 5000’s value weekly.

That spring, while the investment community was preoccupied with May Day (the end of fixed brokerage commissions), Vanguard Group launched First Index Investment Trust, the first S&P 500 index fund geared to retail investors. “When we came out with the fund,” recalls Bogle, who formed Vanguard in 1974, “it suddenly became a lot more important to beat the S&P 500.” Portfolio managers could no longer pooh-pooh the index as a hypothetical benchmark.

Vanguard’s index fund grew modestly; assets reached just $80 million by 1980. But its very existence enhanced the S&P 500’s status. “The industry sort of collectively came to the conclusion that the S&P 500 was the best way to measure the performance of the stock market,” says Kelly Haughton, head of online services at consulting firm Frank Russell Co. Russell launched a rival broad market index , the Russell 3000 , in 1983. Presciently, it also created a family of style-specific indexes covering small-cap, midcap and large-cap stocks, as well as growth, core and value.

The 1980s saw a boom in indexing, almost entirely dedicated to the S&P 500. Pension funds directed nearly $200 billion into passive strategies tied to the index, or roughly one out of every four pension dollars. On the retail side, Vanguard’s S&P 500 mutual fund amassed $4 billion in assets during the decade. Standard & Poor’s, which in 1966 had been acquired by McGraw-Hill Cos., realized that in the S&P 500 it had created a powerful symbol and proceeded to cash in on the index. “They were sitting on an amazing trademark with the S&P 500 and have been milking it ever since,” says Douglas Arthur, a publishing analyst at Morgan Stanley. In the mid-1980s futures and options based on the S&P appeared. In the early 1990s the company also collaborated with consulting firm Barra to create a suite of growth and value indexes to compete with Russell. And in 1996 S&P even flirted with the notion of getting into money management, considering, and then abandoning, the acquisition of Van Kampen/American Capital, which Morgan Stanley bought in 1997.

Pension plans that didn’t convert to indexing nevertheless pressured their managers to at least match the S&P 500’s returns, net of fees. The implied (or explicit) threat: If the managers couldn’t beat the index, they would be cut loose and replaced by index funds or by managers that could.

The pressure to beat the bogey only intensified as indexing spread to the retail market. Retail and institutional assets passively invested in the S&P 500 swelled from $235 billion in 1991 to $370 billion in 1995. Relentlessly, the S&P extended its reach: By 1996 nearly $500 billion was passively invested in the index; in 1997 it was $625 billion; in 1998 $700 billion; in 1999 $900 billion; in 2000, $1.25 trillion.

But competing market indexes began to make significant inroads into the S&P’s territory. The assets devoted to the Russell 3000 and other Russell indexes grew from $88 billion in 1996 to $116 billion in 1999 and to $214 billion at the start of this year. From virtually nothing in 1995, assets passively managed in the Wilshire 5000 have surged to upwards of $50 billion.

McGraw-Hill, ever alert to opportunities to broaden its flagship index’s franchise, is said to be contemplating S&P exchange-traded sector funds, so that investors can buy baskets of tech, health care or consumer goods stocks.

Only the investment industry’s elder statesmen can recall a simpler era when money managers picked stocks because they thought that they would be good investments, not because their names appeared in the S&P 500 or some other index. “In the old days, back in the 1970s, money managers didn’t look over their shoulders at the S&P 500,” sighs Gil Beebower, a pioneer of performance measurement at A.G. Becker. Progress, of course, has its price.

Harry Markowitz’s inefficient-market theory

Harry Markowitz was just 24 when he published an article in the March 1952 Journal of Finance that would transform investing. His 14-page “Portfolio Selection” introduced modern portfolio theory. Markowitz identified a revolutionary method of constructing a diversified portfolio to produce the most consistent returns possible in the most risk-effective manner possible. He called it the “efficient portfolio.”

The late Merton Miller, the finance theorist who shared with Markowitz and William Sharpe the Nobel Prize for economics in 1990, called Markowitz’s approach “the equivalent of the Big Bang theory in finance.”

Like most insights in finance, it built on the work of others. Holed up in the University of Chicago business school library in the autumn of 1950, graduate student Markowitz became immersed in John Burr Williams’s The Theory of Investment Value, published in 1938. Markowitz got to thinking about Williams’s assertion that owning a full range of assets , stocks, bonds, cash, property , helped to offset market uncertainty.

“Williams talked about how buying a lot of stocks would mitigate uncertainty , but he didn’t talk about using efficient combinations,” recalls Markowitz. “Even when you diversify, if the risks are correlated, there’s still risk left in the portfolio. I was a chess player, and I intuitively thought about things in terms of multiple moves and combinations.”

But it was not until 1959, when he was working at the Rand Corp. in Santa Monica, California, that Markowitz expanded his 1952 article into a book, Portfolio Selection: Efficient Diversification of Investments. In it he developed a “portfolio optimizer” model to allow investors to achieve efficient diversification by inputting stocks’ historical returns, their standard deviations (or variances) and their covariances with other stocks.

A year after Markowitz published his book, Sharpe, a young UCLA doctoral candidate in economics, sought him out to ask for advice on a dissertation topic. Markowitz told him that he had never fully explored the market model for factoring in all of the covariances among stocks within a portfolio. Sharpe’s 1963 dissertation , “Portfolio Analysis Based on a Simplified Model of the Relationships Among Securities” , did precisely that.

A year later Sharpe introduced his capital asset pricing model, which posits that the only truly efficient portfolio is one that mimics the market , that is, a “passive” index portfolio.

Sharpe and Markowitz may have shared the Nobel prize, but that doesn’t mean they agree on everything.

“I never said that the market was efficient,” asserts Markowitz, who at 74 still works as a part-time financial consultant and occasional visiting professor. Fifty years after his own famous paper was published, Markowitz disputes a key theoretical assumption underlying Sharpe’s CAPM: that investors can borrow as much as they want, risk-free. “He made that assumption to keep the math tidy,” contends Markowitz, “but if you reject that premise, it throws the whole conclusion off. In fact, the market is not efficient.”

Sharpe, now 67, replies: “Harry’s concern was with the assumption that investors could borrow or lend at the same rate of interest. Since then models have been developed that make more realistic assumptions. The issue of the efficiency of the market or lack thereof is a complex one. Some think it is very hard to beat the market or an index fund that tracks the market. Others think it is relatively easy. It is fair to say that I fall closer to the first end of the spectrum than Harry does, but I doubt that we are very far apart.”