How the S&P 500 Rebalance Affects Index Funds By John Spence August 1, 2002

Standard & Poor's index committee decided in July to replace seven foreign stocks in the S&P 500 with domestic ones, and the shift affects countless index investors. For example, the Vanguard 500 fund was the nation's largest mutual fund at the end of June, with over $69 billion in assets according to Morningstar. The move represents one of the biggest changes in the history of the S&P 500, which has an estimated $1 trillion benchmarked to it.

The "index effect"

Should S&P 500 index fund investors rejoice the committee's decision to rebalance the S&P 500 because of the so-called "index effect" and the potential for higher returns?

During the bull market of the late 1990s, many observers wondered if the popularity of indexing the U.S. market through the S&P 500 was a self-fulfilling prophecy due to its widespread use. Their argument was that new additions to the index experience a price "pop" as index funds are required to buy shares to reflect the index change. Therefore, the argument goes, S&P 500 index funds returns are pushed higher and higher as a result of artificial "index effect" positive performance.

However, this line of reasoning is flawed for several reasons that have been uncovered by research on index effect. Although stocks added to the S&P do experience a price spike initially, the effect is not permanent. Essentially, the excess performance is reversed over the next year. Research on stocks booted from the S&P 500 shows that they experience temporary price declines that are reversed within a week after index rebalancing. For much more on this subject, see Larry Swedroe's synopsis of the academic and industry research in this previous IndexFunds.com article.

Many industry analysts feel the index effect is shrinking and that the days of gaming index rebalances may be a thing of the past.

Index additions and the ripple effect

Index additions and deletions impact all of the stocks in the index, at least from a passive manager's point of view. When one stock is dropped and the added stock is of unequal size, index funds must also rebalance all the other stocks in the index.

For example, if the added stock is smaller than the deleted stock, the fund will wind up with excess cash on hand. Therefore, the index fund must buy more shares of all the other stocks in the index to remain fully invested. This is one of those instances where index fund managers can add value with savvy trading and the use of futures.

Why now?

David Blitzer, chairman of the S&P index committee, said that mid-July was an opportune time to make the changes because it would minimize turnover in the index and allow fund managers to more easily handle the transition. According to S&P, the sales from the deletions nearly offset the buys from the additions. The deletions made up 1.98% of the index's market capitalization, while adds made up 1.68%.

The result is a slight net buy position for the remaining 493 stocks in the index. This contrasts with the 1983 situation when the seven Baby Bells were added, which resulted in a net sell position for the remaining stocks because the adds were significantly bigger than the deleted stocks.

"Plus, this is a year of unusually low S&P 500 index turnover due to the low number of mergers and acquisitions in the large cap sector, so we are making the change at a time when the impact on index investors will be minimalized," said Blitzer in a statement.

The bottom line

The recent changes to the S&P 500 index should be viewed as a positive - the S&P 500 is a domestic benchmark after all. The deleted companies (two European and five Canadian) entered the index before S&P developed its international and global indexes, and they were causing problems.

"Increasingly, users of the S&P 500 have told us that the inclusion of non-U.S. companies in the index makes the index more difficult to use for investment and risk control purposes," noted Blitzer. "The change will mean that index funds and exchange-traded funds can expect lower operating and transaction expenses and less tracking error."

So the changes should make the S&P 500 a better benchmark for index investors over the long haul despite the short-term turnover, which S&P took steps to minimalize. Because of its immense popularity and committee format, the S&P 500 is unique compared to objective rule-based indexes. The committee must carefully consider the possible market impact and costs that would result from even minor tweaking.

References

• Focusing The S&P 500 On U.S. Large Cap Stocks And The Removal Of Non-U.S. Companies In The S&P 500. Standard & Poor's Index Committee. July 9, 2002.
• “The Growth of Index Funds and the Pricing of Equity Securities: No Evidence That Indexing Influences Security Prices.” Burton G. Malkiel and Alexander Radisich. Journal of Portfolio Management, Winter 2001.
• S&P 500 Index Changes, Predicting and Capturing the Impact. Sandy Rattray, et. al. Goldman Sachs, January, 2002.