The S&P 500 Index Fund, and derivative ETF products such as the widely-followed S&P 500 SPDR (SPY), are perhaps the most common equity-based indexing instruments on the market today. The pioneer of index mutual funds, the Vanguard Group, defines indexing as follows (1):
Instead of hiring fund managers to actively select which stocks or bonds the fund will hold, an index fund buys all (or a representative sample) of the securities in a specific index, like the S&P 500 Index.
The goal of an index fund is to track the performance of a specific market benchmark as closely as possible. That’s why you may hear it referred to as a “passively managed” fund.
Vanguard’s founder Jack Bogle launched the first index fund for investors in 1976, and his book Common Sense on Mutual Funds convinced a whole generation of investors that active management was a loser’s proposition after fees were deducted. Mr. Bogle created the “indexing revolution” on the concept that passive management is a superior approach for the average investor, promoting a strategy that ran counter to “hiring fund managers to actively select which stocks…the fund will hold.” Vanguard has inspired millions of Bogleheads and financial advisors across the country to use index funds in their practice.
But passive investing is a misnomer, at best. It is misleading, at worst.
In the case of the S&P 500 Index Fund and its derivatives, investors have simply chosen “fund manager” Managing Director David Blitzer and his committee at S&P Dow Jones to assign individual equity exposure to the index on an active basis. The S&P 500 has momentum rules, fundamental rules, and even a subjective overlay via a committee process (2). Between January 2005 and January 2015, 188 of the S&P 500 index components were replaced by other components (3). On the basis of our data assessment, there are fewer than 70 companies in the present-day S&P 500 Index that were even trading publicly 35 years ago, let alone included in the S&P 500 at that time.
Perhaps more surprising that the S&P 500 Index and its ETF derivatives are “active management in disguise” is that research suggests that the S&P 500 Index Fund has actually underperformed a less actively-managed index, its prior self. According to a study performed by professor Jeremy Siegel, author of the famed Stocks for the Long Run, “the more than 900 new firms added to the index since it was formulated in 1957 had, on average, underperformed the original 500 firms in the index…Investors were better off had they bought the original S&P 500 firms in 1957 and never made any changes to their portfolio (4).”
That the committee that selected the stocks to include in the S&P 500 in 1957 did better than the subsequent and ever-changing S&P 500 Index Fund and a large number of fund managers since that time doesn’t mean that a passive strategy is better than an active one. Instead, the takeaway is quite the opposite: the results mean that an active stock selection process will always be a key determinant of long-term equity investment returns, even under seemingly “passive” strategies. Indexers aren’t really passive investors, but deliberate investors. They’ve just selected a different kind of fund manager.
(1) https://investor.vanguard.com/mutual-funds/index-funds?WT.srch=1&AdGroup=IndexFund-S&P
(2) Index Methodology – S&P 500 Dow Jones Indices
(3) https://en.wikipedia.org/wiki/S%26P_500
(4) http://www.etf.com/sections/index-investor-corner/22846.html?nopaging=1