Secrets about the S&P 500 Index that you should know

Wednesday March 7, 7:15 pm ET
By Jonathan Burton Secrets about the S&P 500 that all investors should know

SAN FRANCISCO (MarketWatch) -- The Standard & Poor's 500 Index may be the market benchmark that U.S. stock investors have come to know best over the years, but as with any long-term relationship there are secrets that build up between partners.

At face value, the S&P 500 (CDNX:SPX.V - News) seems a ticket to mediocrity, a boring "buy-and-hold" strategy that guarantees the U.S. stock-market average and nothing more.

But this buttoned-down benchmark has a racier side. If you're a long-term shareholder in a mutual fund or exchange-traded fund that mirrors the S&P 500, or if you're banking on a large-cap portfolio manager to beat the index over time, a look under the hood might be surprising.

For starters, these 500 large U.S. companies, ranked by market value, are a dynamic group that reflects the world economy, not just the U.S. market.

Moreover, size matters -- the biggest companies dictate index performance. Stock dividends are crucial as well, accounting for one-third of the benchmark's historical return.

And the S&P 500 kicks sand on market timers. Since its introduction on March 4, 1957, after Standard & Poor's Inc. combined 500 U.S. stocks in four indexes into a single entity, the index has returned 10.8% annualized. Had you staked $1,000 that day and reinvested dividends, you'd have more than $170,000 now.

If over that half century you tried to time the market but missed the index's 10-best months, you'd have to make do with around $52,000.

"It remains, in spite of its weaknesses, the preeminent index," said John Bogle, founder of mutual-fund giant Vanguard Group. It was Bogle who made the S&P 500 accessible to individual investors in 1976 with the first retail index fund, the Vanguard 500 Index Fund (NASDAQ:VFINX - News). "It's proved itself."

Indeed, the S&P 500 is a litmus test both for investors striving to outperform the market and those satisfied with market-matching results. An estimated $1.3 trillion is given to mutual funds and other portfolios directly tied to the benchmark. The Vanguard 500 fund alone commands about $190 billion, making it the largest indexed offering.

Another $4.5 trillion -- almost one-third of the U.S. market's $14 trillion value -- is deposited with investment firms that justify their fees by comparing their performance with S&P 500. "Did you beat the benchmark?" is the bottom line for mutual-fund managers and other investment professionals who trade larger-capitalization U.S. stocks. Just three in 10 managers in any given year can make that claim against the S&P 500.

"It's a formidable opponent," said Burton Malkiel, a Princeton University economics professor and author of the classic "A Random Walk Down Wall Street," which advocates index-fund investing. "Year after year it is a benchmark that is extraordinarily difficult to beat."

Dynamic doings

Some people see indexing as a static, sanitized investment strategy. To be sure, the S&P 500 represents about 75% of U.S. stocks by market value, but it's hardly monolithic. Just 86 of the original 500 companies are still in the index today. The others were either acquired, failed or dropped from the ranks.

"The U.S. market is changing, and the index changes with it," said Howard Silverblatt, senior index analyst at S&P. See related story.

Those changes haven't always been for the better. The S&P 500's strength -- ranking stocks by market value -- can be a weakness. In runaway bull markets especially, the index can become a poster child for speculative excesses. When investors ignore valuation and bid shares of the biggest companies to stratospheric heights, the index can become dangerously unbalanced.

Today, about 18.5% of the S&P 500 is tied to technology and telecom stocks. That's second to financials, at 22% of the index's total value. Add the health-care sector, at 12%, and more than half of the index is represented.

But at the peak of the technology boom in March 2000, for instance, high-flying tech stocks commanded 34.5% of the S&P 500, while the equally heated telecommunications sector reflected another 7.4% -- effectively transforming the benchmark into a large-cap tech and telecom index just when many of these stocks were priced to perfection.

In the resulting bear market that persisted through most of 2002, index-fund investors found no shelter as the S&P 500 lost half its value. After that painful episode, traditional indexing came under attack. Newfangled mutual funds and ETFs now cut the S&P 500 into creative slices, ranking stocks on earnings and valuation measures, dividend yield and even an "equal-weighted" portfolio that gives all 500 companies a 0.20% share of the index regardless of market capitalization.

Such alternatives are not only less risky than a market-cap weighted index, but they also outperform, says Jeremy Siegel, a Wharton finance professor and a director of WisdomTree Investments, which offers ETFs that rank stocks based on dividends and earnings. He said that tests of this strategy show "better resistance in down markets, less volatility and higher return."

Global portfolio

To most investors, the S&P 500 is the stock market's apple pie, a uniquely American product. In fact, while the benchmark companies are U.S.-based, their customers are increasingly global. The S&P 500 has so much total international-sales exposure, your stock portfolio might not even need a separate international component for diversification.

About 45% of the revenue of S&P 500 companies comes from outside of the U.S., and that figure could hit 50% by the end of the year, according to Silverblatt, the S&P analyst.

For example, Exxon Mobil Corp. (NYSE:XOM - News), the biggest S&P 500 company at 3.3% of the index, derives around 70% of its sales outside of the U.S., while No. 2 component General Electric Co. (NYSE:GE - News), a 2.9% index position, brings in half its revenue from abroad.

"It's like buying a global stock fund," Silverblatt said. "You do have a lot of direct and indirect foreign exposure."

Size matters

With indexing, bigger isn't always better, but it is stronger. The S&P 500 is a concentrated index, and stocks with the largest market value -- stock price multiplied by the number of publicly available shares -- have the greatest influence on index returns.

The top 10 constituents in the S&P 500 now account for 20% of the benchmark, and the 50-biggest companies make up almost half the index. So far this year, for example, shares of the five biggest S&P 500 members have lost 6.9% on average, and the top 10 are off 3.7%. The index overall has shed about 1.6%. By comparison, an equal-weighted S&P 500 index is up about 0.50%.

"The intent of the index is to represent the market, and not to pick the best issues or the worst issues," Silverblatt said. "They have liquidity, size, representation and profitability. We also have many issues that are not making money, but that's the way in the market."

10 largest S&P 500 stocks

Company	Ticker	Market Value (Bil)	Index Weight
Exxon Mobil		$418.1	3.31%
General Electric		359.9	2.85
Citigroup	(NYSE:C - News)	247.5	1.96
Microsoft	(NasdaqGS:MSFT - News)	243.7	1.93
AT&T	(NYSE:T - News)	230.4	1.82
Bank of America	(NYSE:BAC - News)	228.3	1.81
Procter & Gamble	(NYSE:PG - News)	201.2	1.59
Johnson & Johnson	(NYSE:JNJ - News)	182.5	1.45
Pfizer	(NYSE:PFE - News)	180.0	1.43
Altria Group	(NYSE:MO - News)	176.6	1.40

Data: Standard & Poor's Inc. (As of 2/28/07)