The world’s most-followed benchmark isn’t as passive as you think.
In Mebane Faber’s new book, “Global Value,” he states: “It is ironic that the largest and most famous index, the S&P 500, is really an active fund in drag. It has momentum rules (market cap weighting), fundamental rules (four quarters of earnings, liquidity requirements) and a subjective overlay (committee input). Does that sound passive to you?”
While we could debate extensively whether or not the S&P 500 Index is actively managed, I agree that it is. For me to consider the S&P 500 passive, it would have to comprise the top 500 stocks by market capitalization or, failing that, use rules-based screens with no reliance on the subjective judgments of committee members.
With that said, the real question is, Why does it matter if the S&P 500 is actively or passively managed? One reason the distinction might be important is because of an argument often raised by supporters of active management. They contend that the S&P 500 is not a fair benchmark because it’s really an actively managed index. Let’s examine if that claim has any validity.
Is The Benchmark A Good One?
Unlike the CRSP (Center for Research in Security Prices at the University of Chicago) and Russell indices—which are based purely on objective measures, such as market capitalization—the S&P 500 is selected by a committee at S&P Dow Jones Indices headed by David Blitzer. As such, the index changes—new companies are added and old ones are deleted—on a fairly regular basis. For example, nearly one-third of the index components changed between January 2000 and June 2005.
To determine if the “charge” that the index is incorrectly used as a benchmark has any validity, we can compare the returns of the S&P 500 to completely unmanaged indices. The Russell 1000 Index, started in 1979, is an index of the 1,000 largest companies. For the 35-year period ending in 2013, the Russell 1000 returned 12.03 percent per year and the S&P 500 returned a virtually identical 11.96 percent per year.
Another good benchmark for the S&P 500 is the CRSP Index of large-cap stocks, which uses deciles 1-5 of all stocks ranked by market capitalization as determined by NYSE stocks. Since the S&P 500 began life in 1957, we can compare the returns of the two indices for the 57-year period ending in 2013. Again, we find that the two indices provided virtually identical returns. The S&P 500 returned 10.06 percent per year and the CRSP 1-5 returned 10.12 percent per year.
The conclusion we can draw is that it makes no difference which index we use as a benchmark for active managers—the majority fail to outperform. Another conclusion we can take away from these comparisons is that a lot of smart people at the S&P committee appear to be wasting lots of time that could be spent on more productive endeavors.
Jeremy Siegel, professor of finance at the Wharton School of the University of Pennsylvania, provided us with further evidence supporting this conclusion. In a study, Siegel found that the more than 900 new firms added to the index since it was formulated in 1957 had, on average, underperformed the original 500 firms in the index.
Continually replenishing the index with new, faster-growing firms while removing the older, slower-growing firms lowered returns to investors. In other words, the committee’s efforts were counterproductive—investors would have been better off had they bought the original S&P 500 firms in 1957 and never made any changes to their portfolio.
Since the S&P 500 outperformed the majority of mutual funds during this period, buy-and-never-sell investors would have done better than most mutual funds and professional money managers over the last 48 years. That’s quite a feat to accomplish with no effort whatsoever. And these results would have been achieved with far greater tax efficiency.
Even more importantly—since these buy-and-never-sell investors would not have expended any effort trying to pick stocks, time the market or identify superstar managers—they would have had more time to enjoy the really important things in life.
The bottom line is that Faber’s point about the S&P 500 not being a truly passive vehicle is totally irrelevant to whether active management is likely to be the winning strategy. In fact, it could be argued that the lack of any outperformance by the S&P 500 relative to purely passive benchmarks, such as the Russell and CRSP indices, makes the case for passive investing.
Larry Swedroe is the director of research for the BAM Alliance, a community of more than 130 independent registered investment advisors throughout the country.