What people say about the S&P 500 is interesting, in a pedantic sort of way, and I like that sort of stuff, in a trivia-contest sort of way. But always think about the possible motives for devoting such attention to relatively small details.
It's an attack on indexing itself, by attacking the best-known index. "The S&P 500 is actively managed" has almost become a meme. The followup, implied or explicit, is "...you say you aren't interested in what I'm selling because you're a passive investor, but you aren't
, so go ahead, why not?" That O'Doul's you're drinking isn't really
non-alcoholic, it's 0.5% alcohol, so go ahead, why not...
Here's my "attack" on the S&P 500. It's supposed to measure U.S. stocks; S&P itself says "The S&P 500® is widely regarded as the best single gauge of large-cap U.S. equities." Yet it includes international stocks! Yes, it does! Check it out: Mylan N.V.
, Schlumberger, Ltd
., Garmin Ltd
. How come they're not "Inc.?" Because they're foreign, that's how come! Look it up. So what? Who cares? It doesn't matter; it's trivia-contest stuff.
The big spin in Brown's article is that his block pictures and his characterization of the index as "created actively" and "an art, not a science" entirely concern arbitrariness in the sector classifications within
the index itself. He complains about "rivals Wal-Mart and Target being in two different sectors (Staples and Discretionary, respectively)"--but it doesn't matter. It's a cap-weighted index. That's part of the virtue of a cap-weighted index. Walmart Stores is about 0.6% of the S&P 500 index by cap-weight. If it were reclassified tomorrow into Discretionary, it would still be 0.6% of the S&P 500 by cap-weight. Vanguard wouldn't need to buy or sell one share of stock
to update to the "new" composition.
A fact like "REITs were spun out of the Financials and are now their own sector – at 3% of the whole" just doesn't matter to an S&P 500 index investor. It certainly affects someone who owns a financial sector
fund or ETF that tracks the S&P Financial Select Sector Index, such as XLF. It certainly affects someone who is using an index that isn't
cap-weighted--one in which, perhaps, the allocations have been adjusted to invest the same number of dollars in every sector. It doesn't affect an S&P 500 index investor. It doesn't affect a total market investor.
It is not a "massive distraction for investors to obsess over how they’re doing versus a passive index that is, itself, created actively" for an obvious reason: you can, in fact, easily invest in any of a number of very inexpensive funds that come within a few basis points of tracking the index. It's not at all irrelevant to compare your performance with that of a dead-easy, dead-cheap alternative.
The obvious question to ask is "Suppose the S&P 500 were
truly passive. Suppose it just consisted of the largest companies by capitalization, instead of a committee choice of 'leading companies in leading industries?'" How much difference would it make? We can almost answer this and it's trivially easy. The Vanguard Large-Cap Index Fund tracks the "CRSP US Large Cap Index," which currently contains 611 stocks, and you can read the selection rules
No guff about "leading companies" or "leading industries" there.
The Russell 1000 is another well-known rules-based, transparent large-cap index.
So let's look at the difference between the Vanguard 500 index fund, VFIAX, tracking the "active" S&P 500 index (blue); a real fund with real money that tracks Russell 1000 index (iShares IWB, orange); and a real fund with real money that tracks the CRSP US Large-Cap Index (Vanguard's VLACX, blue).
So if you own an S&P 500 index fund, the next time Brown asks you about your investments you can say "I'm a passive investor in the CRSP Large-Cap Index." And if he says "Oh, you own the Vanguard Large-Cap Index fund?" you can reply "No, I own the Vanguard 500 Index Fund--it's close enough."
Annual income twenty pounds, annual expenditure nineteen nineteen and six, result happiness; Annual income twenty pounds, annual expenditure twenty pounds ought and six, result misery.