Your Complete Guide to Index Investing with Dan Bortolotti

The S&P 500 Effect

2017-12-02T22:35:31+00:00February 10th, 2010|Categories: Indexing Basics|Tags: |9 Comments

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.

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