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The Poor Standard of Standard & Poor'sHow the S&P 500's bad bubble-stock picks have cost investors billions.

By Daniel GrossPosted Thursday, Aug. 1, 2002, at 12:55 PM ET

For decades, investors have regarded the highly diversified Standard & Poor's 500 as a safe place in which to plow long-term investments. For most of the '90s, Americans were hectored to invest their money in S&P 500 index funds. Champions of the S&P 500 boasted incessantly about how S&P index funds crushed most mutual funds and stock pickers, all while charging lower management fees. But in the past two years, the safe S&P 500 has proved to be even more dangerous than the rest of the market. While the Dow is off 26.6 percent from its 2000 peak, the S&P 500 is off a whopping 40.6 percent.

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The index is one of the more unlikely villains of the bubble. Despite perceptions, the index is not a passive investment vehicle. Instead, S&P is constantly choosing new stocks and booting old ones. And in the past few years, S&P's modus operandi—which receives surprisingly little scrutiny—led it, essentially, to recommend that investors buy highly speculative companies at or near their tops.

Standard & Poor's traces its roots to 1860, when Henry Varnum Poor, author of the definitive History of Railroads and Canals in the United States, started supplying financial data to investors. His company began to rate bonds in 1916 and merged with Standard Statistics in 1941 to form S&P. Since 1966, it has been part of the McGraw Hill empire, which also includes Business Week.

S&P has compiled an index of 500 leading companies in critical industries around the world since 1957. (Today, it includes only U.S. companies.) And while it typically doesn't get as much press as the Nasdaq or the Dow, the S&P 500 is far more important than either. Because of its breadth and diversification, the S&P 500 is the crucial benchmark for professional investors. Investments by insurance companies, pension funds, college savings funds run by states, and public employee pension funds are either invested in the S&P 500 companies or mimic its makeup closely. "The S&P 500 is used by 97 percent of U.S. money managers and pension plan sponsors," S&P's Web site proudly notes. "More than $1 trillion is indexed to the S&P 500." (That sum is almost certainly lower now.) About 8 percent of the shares of every S&P 500 stock are held by index funds. As a result, S&P's eight-person Index Committee, which selects the companies that enter and leave the S&P 500, is a far more influential stock picker than Warren Buffett or Fidelity manager Peter Lynch.

When a company merges with another index company, or is acquired by a foreign concern, or files for Chapter 11, the S&P committee automatically deletes it. And some companies simply wither away to the point where the committee—which remains anonymous to forestall lobbying—determines them to be too insignificant to merit inclusion.

Between 1990 and 1994, the committee made an average of about 13 changes each year. But with the surge of merger and acquisition activity in the late 1990s, the need for deletions rose. Between 1996 and 2000, the committee changed an average of 40 companies each year. In 2000, a record 58 changes occurred.

The Index Committee, which meets regularly to evaluate potential targets for inclusion, is guided by several long-standing criteria. Companies added are supposed to be representative of the American economy. They should have market capitalizations of about $4 billion or more and should have the largest market values in their sectors. They must also show four consecutive quarters of profits. The committee also uses new additions to ensure that the index remains representative of a highly dynamic economy. If a health-care company leaves, it is generally replaced by a health-care company. But if a company in a declining industry leaves—say a steel manufacturer—the committee might choose to replace it with a company in a rapidly growing industry, like software or telecommunications.

It's easy to see how the standards, which had generally served the index well, were affected by the bubble. Historically, company and industry market capitalizations have been highly correlated with their commensurate roles in the American economy. But that relationship went wildly out of whack in the late 1990s, as companies with relatively small revenues—Yahoo!, Amazon.com, Qualcomm, etc.—became worth far more than giant companies like General Motors and Sears. Suddenly needing to fill a large number of openings, the committee turned to these initiates.

By and large, dot-coms didn't make the S&P 500, largely because they couldn't report profits. But in 1998 and 1999, telecommunications, software, and fiber-optic companies started to trickle in; in 2000, that trickle became a flood.

AOL was arguably the first New Economy stock granted entree into the S&P 500. It entered at the close of 1998, replacing Venator, the parent company of Foot Locker. Network Appliances entered on June 24, 1999, followed soon after by Qualcomm on July 21, Global Crossing on Sept. 28, and Yahoo! on Dec. 7. The tech-tilted makeover accelerated throughout 2000.

The problem was not that these companies were added—it was clear that they represented an important part of the economy—but when they were added. S&P essentially took many of these speculative companies at or near their tops. When Yahoo! came in, it traded at an astronomical 228 (it's now at 13); Qualcomm traded at 159.75 when it was initiated into the club, and now it trades at 27.

S&P also contributed to the frothiness surrounding these stocks. When S&P announced an addition, it became clear that every public fund that uses the S&P 500 benchmark would have to buy that stock on the date of its inclusion. Guess what that did to the fortunate stocks?

On the day Yahoo! joined the S&P 500, it rose 67 points. And in the week between the announcement and the actual inclusion, Yahoo! rose 136 points, or 64 percent. According to a 2000 study by Salomon Smith Barney, stocks selected for inclusion outperformed the S&P 500 by 7.7 percent in the period between the announcement and the inclusion. The net effect: S&P 500 mutual funds—that is, you—effectively bought these new stocks at artificially inflated prices.

Some of the moves the committee made in 2000 turned out to be enormously bad for S&P investors, adding volatile, incredibly overpriced stocks to the index. On Jan. 28, 2000, Consolidated Natural Gas was replaced by Conexant—then an $88 stock, now a $2 stock. On March 31, auto-parts company Pep Boys was replaced by Veritas Software. On May 4, out went Reynolds Metals and CBS, in came Sapient (a $102 stock) and Siebel Systems. On July 26, JDS Uniphase subbed in for Rite Aid. And on Nov. 3, PaineWebber was swapped for Broadvision. Of the 58 stocks entering the index in 2000, 24 were Nasdaq stocks.

Joining the S&P 500 conferred a greater legitimacy on the companies and brought in a whole new class of institutional buyers who, by virtue of their mandate to follow the S&P 500, had to own the newly selected stocks. By virtue of their mandate to follow the S&P 500, they also had to hold them all the way down.

Throughout 2000 and 2001 many of the multibillion-dollar new initiates plummeted and were unceremoniously ejected from the index. Sapient, for example, was booted out after less than two years, having lost 98.4 percent of its value. Broadvision, worth $23 billion at its peak (it's now worth just $98 million), got axed after just 10 months. Conexant got disconnected last June, 30 months after its inclusion.

Investors who plowed funds into the S&P 500 thinking they were getting a conservative barometer have been sorely disappointed. Sure, the S&P 500's performance hasn't been as abysmal as the Nasdaq's—off 74 percent from its 2000 peak. But because the S&P 500 dictates the investments of millions of investors, its decline has been far more destructive.

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Daniel Gross is the Moneybox columnist for Slate and the business columnist for Newsweek. You can e-mail him at and follow him on Twitter. His latest book, Dumb Money: How Our Greatest Financial Minds Bankrupted the Nation, has just been published in paperback.

COMMENTS

Notes From The Fray Editor:

As the scandal grows more technical (I mean, two posts with the phrase "dollar-cost averaging?), the posts get less pithy, but actually begin to take on the substance of a well-run debate, with each new idea tested in the acid bath of The Fray. Below are some of the more persuasive jabs at Gross's argument.

Note II:

Moneybox has been an extremely active department, what with the continuing crisis and all. Readers who plunge into The Fray may have a hard time sorting out posts unless they have read (the ledes) of the recent spate of articles. See the drop down menu on the left hand side under Business for a list.

Remarks From The Fray:

Times have certainly changed. A couple of years ago, when the market was skyrocketing and investors seemingly couldn't go wrong, it was often argued that stock-picking was for chumps--after all, why throw away a percent or two of savings growth a year on managers' fees, or gamble everything on an insufficiently broad portfolio, when an index fund virtually guarantees near-double-digit returns over the long term? Well, now that the market's tanking, Daniel Gross is singing a different tune, criticizing the S&P 500 index for, of all things, being lousy at picking stocks--adding companies to the index just as their share prices peak, and then keeping them on the roster as they collapse.

The charge is, of course, utterly absurd; the S&P 500 is supposed to track the large-cap market, not beat it, and if investors are pumping up dubious tech stocks to absurd valuations, then it's not S&P's place to second-guess their judgment. Moreover, the index investing dogma of the nineties asserted adamantly that such fluctuations shouldn't matter anyway to the long-term buy-and-hold investor, who could look forward to excellent returns by explicitly not timing the market, buying instead at a constant rate ("dollar-cost averaging") year in and year out, and counting on the market's historically reliable high return rate to do its work.

The flaw in this strategy--as we have now all been so painfully reminded--lies in its assumption that stocks' consistently higher return rates are a blessing that simply drops out of the sky into the laps of delighted passive investors. In fact, their true source is the vigilantly skeptical discipline of history's (overwhelmingly active, portfolio-managing) investors, who have made a practice of avoiding stocks whose high prices precluded a sufficient return on their invested purchase price. By refusing to overpay, those finicky investors kept stock prices (relative to earnings) down, and thus returns (per dollar invested) high.

Passive (or uninformed) investors, on the other hand, show no such discipline; they robotically pour their money into index (or, for that matter, actively managed all-stock) funds, regardless of current share prices or prospective corporate earnings. And as their numbers increase, they can exert a significant influence on those share prices, lifting them to the point where the potential earnings (again, per dollar invested) of the companies they represent pale in comparison with the earning power of, say, Treasury bills.

Eventually, of course, sharp-eyed investors begin to notice that they're being fleeced and head for the exits, bursting the bubble and stranding the remaining shareholders with stock worth a tiny fraction of its grotesquely overinflated purchase price. That's exactly what happened to most of the millions of American investors who collectively lost trillions of dollars in the market over the last several years. By comparison, the effects of badly-timed additions to or deletions from the S&P 500 index are a piddling, deck-chairs-on-the-Titanic irrelevancy.

-- Dan Simon

(To reply, click here.)

I am a little confused - is Gross arguing that S&P has some sort of obligation to American investors to choose its composition for maximum returns? S&P picks companies for inclusion in the 500 based on its own criteria, and does not make any representations or promises as to the future stock performance of its picks. The fact that approximately 8 percent of the shares of all S&P 500 companies are owned by large institutional investors is a result of the index having historically represented an accurate cross-section of big-cap companies across a variety of industries. That is to say, the managers of those funds chose peg their performance to the index, either directly or indirectly. The committee at Standard & Poor's doesn't take on some moral or fiduciary obligation just because some critical mass of people have relied upon them in the past.

-- ccy3141

(To reply, click here.)

Gross' article clearly explains a major problem with index funds, which is that they have a tendency to churn at market peaks and cause investors to buy high.

What he left out is that they also tend to churn at market bottoms, and thus provide an opportunity for investors to buy low.

It is sort of like dollar-cost averaging... yes, you will wind up buying a few shares at high prices, but you will also buy many more at low prices for the same money each month.

Gross didn't mention that the S&P is still doing far better than Nasdaq indices, or that the far more diversified Wilshire 5000 is doing almost as badly, and most importantly, that most managed mutual funds are doing even worse than the S&P.

This article was a little too negative.

-- mfbenson

(To reply, click here.)

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