The S&P 500 Effect

On Tuesday, February 16, Berkshire Hathaway will become part of the S&P 500, the most widely followed stock index in the world.

While the Dow Jones Industrial Average is more famous, the S&P 500 is the benchmark for more invested dollars than any other index. The iShares S&P 500 Index Fund (IVV) and the SPDR S&P 500 ETF (SPY) together hold about $85 billion in assets, while the Vanguard 500 Index Fund holds $93 billion, making it one of the largest mutual funds on the planet. Here in Canada, the iShares Canadian S&P 500 Index Fund (XSP) ranks number three among US equity funds with more than $1.27 billion under management.

It will be interesting to see what happens to the market price of these ETFs and index funds on Friday, the last trading day before Warren Buffett’s company officially becomes part of the privileged 500. Some market watchers wonder whether Berkshire’s stock price will spike: indeed, in the two weeks since Standard & Poor’s announced the company’s inclusion, the B-class shares have already shot up more than 8%.

Being added or dropped from the S&P 500 can have a huge effect on a company’s share price. Index funds, by definition, must hold all the stocks in the index they track. So when a new company joins the S&P 500, index funds must start acquiring billions of dollars worth of its shares, creating a demand that can artificially inflate the price. At the same time, they must sell shares of the company being replaced, which can drive down that stock’s price. The result for investors in those index funds is that they often pay too much for the new shares and receive too little for the old ones.

The “S&P 500 effect” isn’t new: in March 2006, when Google was added to the index, its stock price jumped 7.3% in after-hours trading that day. Most famously, we saw it in December 1999, when the share price of Yahoo! rose a staggering 24% the day it was added to the index. The next day it dropped more than 8%, sticking it to investors in S&P 500 index funds that had to acquire the stock at a premium and then watch it plummet immediately.

Despite the S&P 500’s popularity—actually, because of its popularity—investors who want truly passive exposure to US equities should consider the Vanguard Total Stock Market ETF (VTI) instead. First, it holds thousands of mid- and small-cap stocks as well as all the large caps in the S&P 500, offering more diversification (and slightly higher returns over the past five years). More importantly, Its benchmark, the MSCI US Broad Market Index, includes more than 3,500 companies and comprises 99.5% of the US equity market. Nothing significant ever moves in or out of a total market index, so funds like VTI don’t have to make expensive purchases or reluctant sales to track their benchmark. VTI already owns $274 million worth of Berkshire Hathaway and doesn’t need to buy any more this week.

No, it’s not necessary to rush out and dump your S&P 500 index fund. But the Berkshire price changes are a reminder that the S&P 500 is sometimes the tail that wags the dog: instead of passively tracking the market, it winds up influencing it.

8 Responses to The S&P 500 Effect

  1. doug February 10, 2010 at 10:19 am #

    Good analysis of the S&P 500 Effect Dan. Is there data to support the premise that the S&P Index will do better than the Total Market Index (eg: Vanguard) during certain periods – eg: during market recovery after a major correction? And conversely, do worse during other periods? I realize this idea may be inconsistent with the passive investment strategy. For some reason, I am less comfortable with the idea of buying the total market rather than the S&P 500. It may be irrational, but I can’t explain it.

    Would the Claymore US Fundamental ETF (CLU) (which tracks about 1,000 of the largest US companies) be a bit better than the S&P 500 in this regard?

    Also,I am not aware of a Canadian ETF that tracks the US Total Market. If that is true, currency risk is a consideration.

  2. moneyxyz February 10, 2010 at 12:18 pm #

    Good post…this was so educational…didn’t know about this phenomenon…When next I get a wad of $ I’ll buy Vanguard Total Stock Market ETF (VTI).

  3. Canadian Couch Potato February 10, 2010 at 3:28 pm #

    Doug: The S&P 500 will tend to outperform the broad market during periods when large cap and growth stocks do better than mid cap, small cap and value stocks. Historically, small caps and value stocks fall harder during a market downturn and then outperform during the recovery. Over the very long term (since 1926), small and value stocks have outperformed large cap and growth, albeit with more risk.

    Incidentally, because Claymore’s CLU is fundamentally weighted, it has a tilt toward value stocks as well. If you look at its performance over the last several years, it has performed quite differently from XSP. Also note that its index includes about 1,000 companies, but CLU itself holds only about 350.

    Nope, there is no Canadian ETF that covers the total US market, so if you choose to go with VTI you need to be comfortable with the currency risk.

  4. Ben February 11, 2010 at 12:48 pm #

    This is one of the many reasons why I focused my US equity exposure with VTI. The 0.09% expense ratio also shows how far behind Canadian ETFs are. You’re right that as a Canadian investor you need to be comfortable with the currency risk, but ETF investors should generally be longer term anyway and the lower expense ratio justifies it over time.

  5. Ryan February 11, 2010 at 6:07 pm #

    I’ve been tinkering around with the idea of going to a passive ETF portfolio since trading individual stocks can be quite stressful. I know with a passive portfolio, you have to be extremely long term to reap the benefits. But I’m just wondering if it really does work? For example if I bought $5000 worth of VTI in Feb. 07. even if I included the dividends, I’ll be still down over $1000. I know it’s only 3 year time frame but let’s say 10 years from now, how much will I be up?

  6. Canadian Couch Potato February 11, 2010 at 7:19 pm #

    Ryan: Obviously no one knows where the markets will be 10 years from now. Index investing does not guarantee you positive returns: if the markets go down, index funds go down with them. The point is that most actively managed funds will go down more because of costs, and/or failed attempts at market timing. Certainly, some active funds will do better, and some stock pickers will do great. Historically, the vast majority have failed. If you know which ones will succeed in advance, please let me know!

  7. Crawford March 21, 2016 at 9:16 pm #

    My understanding with an ETF is that while we are holders of units in the Fund, we are still in essence an owner indirectly of the underlying securities…my questions are about time of purchase of those units and when we sell them…

    If I bought an passive ETF that did not include Company-A at the time of my purchase, and in the future the Index(that the ETF tracks) adds Company-A, will my ETF units now include Company-A, even though I did not purchase the underlying securities originally?

    Further, does the reverse…If I bought a passive ETF that included Company-A at the time of purchase and in the future Company-A has fallen out of the index(ex. Nortel, Kodak bankruptcy) will I be left holding the bag for underlying securities/partial units that are now worthless?

    In other words, If I am purchasing an passive ETF do the Units represent the Index at that specific period of time, since I have merely bought the underlying securities as they were then?

    Or If I am incorrect, do my units always represent the current underlying securities regardless of when I purchased them? Or is this what an Active ETF is supposed to do?

    Your help is appreciated, hope I was clear enough!…

  8. Canadian Couch Potato March 22, 2016 at 7:36 am #

    @Crawford: When you own units of an index fund, the underlying holdings will change from time to time as the underlying index evolves. If companies get added or deleted from the index, then they get added or deleted from your fund as well.

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