the structure of the S&P 500, and why it matters…

…to us as individual investors, for the portion of our assets we choose to manage actively.

As of the close of trade in New York last Friday, the Standard and Poors 500 was weighted, by sector, as follows:

IT      24.0%

Financials      14.8%

Healthcare      14.1%

Consumer discretionary     12.1%

Industrials     10.1%

Staples      8.1%

Energy      5.8%

Utilities         3.1%

Materials     3.0%

Real estate     2.9%

Telecom      2.0%.

The goal of active managers is to have better results than the index (I could say “an index fund,” but the two are the same, less the small fees an index fund purveyor charges).  We’ll only have different results if we have different holdings than the S&P.  And if our holdings aren’t different–either different names or different weightings (or both)–we can’t be better.  In order to be different our first job is to know what the index looks like.  The list above is a first cut.

Let’s rearrange it to show the sectors in order from the most sensitive to general economic activity to the least.  I’m going to divide the sectors into three groups, from those that do best in a red-hot world economy, those that will still do well with so-so growth, and those that have the most defensive characteristics–meaning they do their best relative to the index when economies are contracting.


most economically sensitive

Materials      3.0%

Industrials      10.1%

Energy     5.8%

————————————-total = 18.9%

economically sensitive

IT      24%

Consumer discretionary     12.1%

Financials      14.1%

Real estate         2.9%

————————————-total = 53.1%


Healthcare     14.1%

Staples     8.1%

Telecom      2.0%

Utilities     3.1%

————————————-total = 27.3%.

I’ve stuck Energy in the most sensitive segment.  Recently it’s been marching to its own drummer, as the big integrated oils restructure and as the crude oil price yo-yos up and down.  Ultimately, though, I think in today’s world oil is just another industrial commodity that’s not that different from steel or aluminum.  Put it somewhere else if you disagree.

This isn’t the only reordering we could make.  We could also arrange the index by market capitalization in order to either emphasize big stocks or small ones in our holdings.  But this is the most common one professionals, and their institutional customers, use.  Personally, I think it’s also the most useful way to think about the index.


To my mind, the most striking thing about the S&P 500 is that it is mostly geared to a rising economy.  If we think recession is brewing, tiny changes in holdings aren’t going to make much of a difference in relative performance.

Another–very important–point is that if you have a portfolio that’s, say, 10% Healthcare, and your benchmark is the S&P 500, you’re betting against Healthcare as a sector, not on it.








index fund gains in the US

According to a survey reported in the Financial Times and done at the newspaper’s request by Morningstar, assets in US index mutual funds now comprise a third of total domestic mutual fund assets.  That’s up from 25% this time three years ago.

Nevertheless, actively managed assets under management have risen by 14%, despite the market share shift.  So the fees being collected by active managers are up.  This is doubtless due mostly to the fact that markets have been rising.  The S&P 500 is up by about a third over the three-year span, the Bloomberg Treasury index by 12%.  Watch out, though, if markets flatten or begin to decline.


More bad news:  the FT is reporting that 90.2% of US active equity managers underperformed their benchmark, after deducting fees, over the twelve months ending June.  Not numbers that will stem outflows.


Since I’m getting such an unbelievably late start today, I’ll only make two points:

–in the investment organizations I’m aware of, management control is in the hands of professional marketers, not professional investors.  I think their giving a much higher priority to selling rather than making products is a substantial part of the underperformance problem for these firms.  It’s highly unlikely, I think, that marketers will volunteer to step down and turn the reins over to makers.  So I expect underperformance issues will continue.  If I’m correct, the next bear market could prove crushing for these organizations, since the combination of falling prices and client withdrawals will doubtless mean sharp declines in profits.  Where will the money come from to beef up research and portfolio management operations then?

–some large investment management firms known for active management are reported to be finally entering the index fund market themselves.  First of all, this seems to me to show the marketing bent of their managements, giving support to my first point.

In addition, index funds have very large economy of scale effects and the oldest/largest have been in existence for decades.  Because of this, I can’t imagine that Johnny-come-lately firms will ever have profitable index offerings.  The firms may subsidize their index funds  so that the fees for you and me will be on a par with bigger rivals’, but I don’t see how the subsidies can ever be taken away.  Yes, such firms may retain assets, but their bottom lines will be worse off than if they retained them.

the record of active fund managers in Europe

I’ve been reading the Indexology blog again.  A few days ago, the topic was the performance of actively managed equity funds managed by European fund managers over the past ten years.

The numbers are almost incomprehensibly bad.

In the “best” category, large-cap European stocks in developed markets there, 55% of the funds underperformed over the past year.  That result deteriorates pretty steadily as time progresses, with the result that on a ten-year view 87% underperform.   .and that’s the best!

The race for last place is almost a dead heat among Global, Emerging Markets and US.  Over the past year, 82% -83% of managers in these categories underperformed.  This result also deteriorates over time.  Over the past ten years, 97% – 98% underperformed.

This is the same pattern as for US active managers   …only worse.

The performance figures are after all fees–management, administrative, marketing…–except for the sales charges levied by traditional brokers.

More importantly, the figures for each period include all funds active during that time, not just the ones that made it through the entire period.  That’s key because over the past ten years about half of the funds active for part of the time were either shut down or (more likely) merged with other funds.  It’s possible that one or two of the defunct funds were great performers but  for some reason couldn’t be sold.  However, in my experience, the overwhelming majority would have been folded because the performance was bad.

Similar figures for the survivors confirms my belief.  The 10-year record for this smaller, hardier, group shows around half the funds outperforming their indices–except for the emerging markets category where over two-thirds of the surviving managers still underperform.

Why do clients put up with this?

One answer is that the absolute returns have been between 5% and 10% yearly in euros.  On the low side that means up by almost 65% over the past decade.  That’s not all that investors could reasonable have expected, but it’s not a loss.  So alarm bells don’t go off when holders get their statements.

Another is that they aren’t.  These sad figures for active managers are the biggest explanation for the popularity of passive products.


a report card for smart beta

Purveyors of “smart beta” equity portfolio strategies have been very popular over the past few years, both with individual investors and with institutions.

The source of the attraction is clear:

smart beta claim to provide better performance than an index fund without engaging in active portfolio management. Actually, it claims to outperform because it doesn’t employ value-subtracting human portfolio managers to muck up the works.  Rather, smart beta operates by reshaping the weightings of stocks in the index according to predetermined computer-managed rules.  (I’ve written about smart beta in more detail in other posts.)

In other words, it’s free lunch.

My observation is that smart beta is a marketing gimmick  …one that has been very successful in bringing in new money, but a gimmick nonetheless.  Basically what it does is to create a portfolio that contains the index constituents, but in different proportions from their index weightings.  The rules for determining the smart beta weightings are set in advance and the portfolio is periodically rebalanced to restore the “correct” proportions.  For my money, the preceding sentence describes active management.  The portfolio managers are just hidden behind a computer curtain.

A simple example of smart beta:  maintain a portfolio of S&P 500 names but have .2% of the money in each stock–rather than having it loaded up with lots of Apple, ExxonMobil, Microsoft, Johnson&Johnson and Berkshire Hathaway.  Historically, this is a strategy that had its best run in the late 1970s – early 1980s, but which followed with a very extended period of sub-par performance.


I was catching up on my reading of the Financial Times over the weekend and came across an article from the FTfm of February 2nd titled,“Smart beta is no guarantee you will beat the market.”

It turns out that of the 10 biggest smart beta ETFs in the US, seven have underperformed over the past three years and five over the past five years.

That’s not that different from what active managers have done.

However, unlike the case for active managers, assets under smart beta management have grown fivefold since 2009.




the FT, Vanguard and Morningstar: active vs. passive investing

Saturday’s edition of the Financial Times opens with a screaming front-page headline, ” $3.5 billion pulled out of Fidelity funds.”  

 …must have been a slow news day.  

The article goes on to explain that net inflows of individual investor cash into the stock market–both in the EU and the US–over the first half of 2014 have been going to index products, not to active managers. 

I can see several good reasons why this is so:

1.  Indexing is like cruise control.  You know you’re going to get more or less the return on the index against which a given index fund/ETF is benchmarked.  So you only have two variables to consider:  how closely the fund/ETF is able to track the benchmark, and what its expense ratio is.  There’s no fretting about an active manager’s style and strategy, or whether he/she is still running the portfolio whose historical record you’re examining

2. Fidelity doesn’t necessarily want mutual fund customers.  I’ve had a Fidelity brokerage account for decades.  Fidelity has never approached me, ever, to buy a mutual fund product of any type.  I presume it’s because the company makes more money from having me trade individual stocks.

3.  Picking active managers takes some effort.  It requires having some understanding of the stock market and an ability to deduce strategy from the lists of holdings that managers report each quarter to the SEC.  

True, there is Morningstar, a service which has been providing its famous “star” rankings of mutual funds for about a quarter century.  Although Morningstar, disingenuously, warns buyers of its star information not to use it as the reason for picking a given mutual fund, people do pay for the rankings.  So they must have a reason.  Investment management companies take out full-page adds to tout their high star-ness.  Inflows seek high-star funds and shun low-star ones.

Over at least the past several years, however, Vanguard points out that following Morningstar rankings hasn’t been a good idea.  The index fund giant is publicizing a study it did of Morningstar fund rankings from 2011 – 2013.  Over the three years, Vanguard says there was a strong correlation between Morningstar star ranking and fund performance, but it was the opposite of what the rankings suggested.  One-star funds performed the best vs. their peers, two-star funds the next best   …and so on, in order, with five-star funds performing the worst.  Whoops!

Personally, I’ve never been a fan of Morningstar’s use of short-term volatility as a measure of the riskiness of a portfolio.  My guess is that the relative stability of a fund’s NAV ends up being the most important factor in getting a high star rating.  So that rating has little to do with future return potential.  But I have no real idea how Morningstar could have gone as badly astray as Vanguard says.

Anyway, to sum up, if there’s any news in the FT article, it’s the (understandable) extent to which individual investors are embracing psssive investing, not the fact that they’re doing so.




types of stock indexes

Indexes can be categorized in several different ways, including:

reach, or coverage


There are broad market indexes like the S&P 500, which cover all the important sectors and contain all the key large-capitalization stocks within a geographical region.  In this case it’s the US.  There are similar indexes for all the other major–and most minor–stock markets of the world.

There are also indexes that cover larger geographical regions, like North America, the Americas, Europe, the EU, Greater China, Asia, the Pacific…

There are also indexes like EAFE (Europe, Australasia and the Far East), which covers the world ex the US and Canada.  It’s purpose is to provide a benchmark for foreign stock portfolios held by US or Canadian investors.  There are similar indexes for the World ex Japan, World ex UK…


There are also indexes that focus on specific sectors or industries, sometimes divided into local and foreign, depending on the portfolio being measured.


There are also indexes that focus only on mid-cap or small-cap stocks, like the S&P 400 (mid-cap) or S&P 600 (small-cap).  With these, the definition of what counts as mid-cap and what’s small-cap may vary from index provider to provider.

investing style

Personally, I find these more problematic, but there are also indexes that claim to contain only value stocks and others that contain only growth stocks.  The sectoral composition of such indexes can deviate wildly from each other, as well as from a larger, style-neutral index.

how the index is calculated

Virtually all today’s stock market indexes are capitalization-weighted.  That is, the effect of the price change of any given stock in the index is based on the total market value of all that company’s outstanding shares.  Stocks where this value is large have more influence on the index movement than whose where the value is small.


Let’s say the index contains three stocks, whose value totals 100.

Stock A has a market value of 70

Stock B has a market value of 20

Stock C has a market value of 10

On a given day, A rises by 1%, B by 2%, C by 3%.

The change in the index is calculated as follows:

(.7 x .01) + (.2 x .02)  + (.1 x .03)  =  .007 +.004 + .003  =  .014

The index rises by 1.4% that day.  The greatest influence on the index performance is stock A because it’s much larger than the other two.

A variation on capitalization weighting is free float weighting.  It may be that in a given country, the government or a powerful family owns a large chunk of one or more large-cap stocks.  The part that’s so held is never traded.  It’s said not to be part of the pubic “float.”  Where this is the case, indexes often weight the stock using only the float, not the full market capitalization.


equal weighting

The Value Line index is an example.  In an equal weighted index, all constituent stocks count the same.  In the example above, an equal-weighted index would be up by 2%.

Versus a capitalization-weighted index, an equal weighted one gives much greater emphasis to smaller stocks.

the Dow and Nikkei Dow

These indexes are wacky.  They use the per share stock price as a weighting factor.  In other words, a $100 stock counts for 10x what a $10 stock does, no matter what the total size of either company is.  To my mind, this is sort of like saying a nickel is worth more than a dime because the coin is larger.

“fundamental” weighting

At one time in the recent past, some investment managers claimed they were offering an index product in which stocks were selected as index constituents either because they had a strong record of high and increasing dividend payments, or because they combined strong earnings growth with modest stock market valuations.

To my mind, this is a marketing ploy.  These are active management offerings, not index funds/ETFs.  The active manager has decided to rely exclusively on mechanical rules that embody his investment judgment.  Many value managers do much the same thing.

As far as I can see, the investment managers I’ve heard making index claims for their products have stopped doing so–with or without the prompting of regulators I don’t know.