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"Passive" Investing in the S&P 500 Doesn't Exist

“I’ll just buy the S&P 500.”  This is the answer that many of today’s investors give when asked about their stock allocation.  Of course, Jack Bogle is a huge advocate of “passive” investment strategies, particularly funds that track the S&P 500.  However, how static is the S&P 500 over time?


First a little history…the Standard & Poor's 500, often abbreviated as the S&P 500, or just the S&P was founded on March 4, 1957. It is an American stock market index based on the market capitalizations of 500 large companies having common stock listed on the NYSE or NASDAQ. The S&P index components and their weightings are determined by the S&P Dow Jones Indices. 


The committee selects the companies for inclusion with the goal of being representative of the industries in the US economy.  Many investors place their faith in mutual funds or ETFs that aim to mimic the decisions this committee makes when investing savings that are important to their and their loved one’s futures.  The current guidelines for inclusion in the S&P 500 are as follows:

  • Market cap should be $6.1 billion or more

  • Stock should be liquid with at least 100% annual turnover of float shares

  • U.S. company

  • Public float greater than 50%

  • Financially viable meaning four consecutive quarters of positive earnings under GAAP

While these inclusion parameters seem straightforward they have been adjusted numerous times since the indexes inception and will undoubtedly change again in the future.  This leads to more turnover than most investors realize.  From the start of 1963 to the end of 2017, 1,259 companies were replaced within the index.  Each year sees approximately 25 companies removed.  These numbers nearly doubled or more during the bear markets of 1976, 2000 and 2007.  Unfortunately, in these instances the committee was often “Selling low and buying high” as companies that were removed during these times were in financial trouble and were replaced by companies that had experienced strong gains prior to their inclusion.


A recent report by Innosight estimates that the turnover trend could increase in the future due to creative destruction.  They found that the average tenure of companies in the S&P 500 was 33 years in 1964 and had dropped to 24 years by 2016.  The report estimates that company lifespan in the S&P 500 will slide to 12 years by 2027.  They believe that fully half of the S&P 500 will turnover in the next decade as well.  What this means for investors is that S&P 500 “passive” index funds and ETFs may end up relying even more heavily on the ACTIVE decisions that the S&P committee makes on what stocks to add to and remove from the benchmark. 


It also means a potential drag on returns as there will be more trading costs with the higher turnover, increased taxes as trading frequency goes up and greater opportunity for traders to front run the index fund managers on stocks added to the S&P 500 index. 


While funds that track the S&P certainly have benefits, as the investing landscape evolves going forward it is imperative that investors are aware of how these shifts could affect their long-term goals and objectives.


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© 2018 by Raisonné & Hammer Price Corporation