When people buy shares in an Index Fund, they assume that they are buying shares in the largest companies available in the United States. You look at Apple, see its $700 billion market capitalization, compare it to the 4% allocation in the S&P 500, and figure it sounds about right. And for much of the 1950s, 1960s, 1970s, 1980s, 1990s, and 2000s, this was true. But in 2005, the S&P 500 shifted from selecting stocks based on market capitalization to selecting stocks based on a market capitalization with a formula that takes into account the free float of the stock.
The consequence is this: Those precious businesses with high insider ownership do not become nearly as represented in the S&P 500 as the market cap of the stocks should suggest. There are 38 stocks that are underweighted in the S&P 500 compared to what the weighting would be if the allocations were based on the size of the business itself rather than the size of shares available for purchase by the public.
Those 38 stocks are: Campbell Soup, Franklin Resources, Wal-Mart, American Standard, AutoNation, Loews, Charles Schwab, Hershey, Kinder Morgan, Computer Associations, Marriott, Quest Diagnostics, K.B. Home, V.F Corp, Pepsi Bottling Group, The Gap, Dow Jones, Ecolab, M&T Bank, Nike, News Corp., Agilent Technologies, Federal Investors, Carnival Corp, Brown Forman, Coca-Cola Enterprises, Gateway, Allied Waste, Kellogg, Autozone, Rohm & Haas, Wrigley, Dynegy, Boston Scientific, Nordstrom, Univision, Dillard, and Danaher.
The problem for investors is that this collection of 38 stocks have delivered better returns than the average component of the S&P 500 since 2005. When you adjust it the figure by the portion these stocks are underrepresented (after all, Wal-Mart is in the S&P 500, it just isn’t as large of a weighting as it should be), you will see that investors have been losing 0.4% annually since the S&P 500 switched from being an index based exclusively on market capitalization to modifying the market cap according to the shares of the stock that are available.
Over long periods of time, this matters. Don’t be fooled by the seemingly insignificant 0.4% annual figure. Imagine setting up a trust fund with $250,000 that has a fifty-year compounding period. If the Trust consists entirely of an index fund that compounds at 9.7%, the ending value is $31.3 million. If the trust, however, is allowed to compound at 10.1%, the final value is $38.1 million. If you have a couple hundred thousand dollars that you want to compound for a long time without interference, this S&P 500 Index change in methodology cost you almost $7 million. These changes aren’t just academic when you’re talking about decent sums of money over a very long time.
For practical reasons, I do understand why the S&P 500 made this move. Think about something like The Vanguard Admiral S&P 500 Index Fund which contains $150 billion in assets. It is a whale in its own right, and is but a large fish in the ocean of index fund investing.
When someone puts money into an S&P 500 Index Fund, you have to pour money into something like QEP Resources which is only worth $3 billion. If the S&P 500 didn’t come up with ways to limit the amount of money flowing to QEP, the amount of people merely buying plain vanilla index funds around the world would cause the valuation of QEP Resources to climb without any connection to the fundamentals. This is true with all investing—when you put $100 into an S&P 500 Index Fund, you are technically putting in a buy order for $4 of Apple stock plus 499 others—but the amount of valuation interference from the S&P 500 is small compared to the active investors deliberately buying and selling Apple stock on purpose.
Even though this shift is understandable for logistical reasons, it doesn’t change the fact that the S&P 500 companies with unusually high insider holdings have a track record of delivering higher returns. Plus, the reason for the outperformance is intuitively persuasive (if you owned a goldmine business, you’d probably be reluctant to relinquish your ownership of it.) And, for the past ten years, investors have been deprived of a proper allocation of these stocks because the S&P 500 chose to underweight large companies with a low free float.
An index fund doesn’t automatically work because it is an index fund. Jeremy Siegel’s research showed that things like reinvested dividends during low valuations and the fact that troubled stocks remain in the S&P 500 (permitting the index to benefit from the subsequent recovery) are the primary reasons why index funds have delivered such great returns. But when you mess with the methodology, you start to alter the mechanics of what has historically made index funds work. And the general rule is proving true that companies with high insider ownership deliver superior returns. It could be because they are conservatively managed (if your net worth is significantly tied to a specific venture, you’re incentivized against taking wild risks) or it could be that the insiders simply know how great the business is.
But the deprival of these businesses from full representation over the past ten years has demonstrably lowered the effectiveness of index investing to the tune of 0.4% annualized. It sounds small, but matters over long periods of time, and is yet another brick in the wall explaining why index funds will encounter further effectiveness problems as they grow in popularity. They are still great wealth-building tools for people that don’t want to spend their life developing investing skills, but the luster shines just a little bit less when methodology tweaks become a logistical necessity.
Originally posted 2015-05-27 17:45:24.