We tend to think of stock market indices as fixed and stable; the same mixture of stocks year over year, which we can benchmark our own investments against. But the truth is, the indices are actually actively-managed portfolios of stocks.
The most recent example of this is the Dow Jones Industrial Average, which is made up of just 30 companies. On September 10, the S&P Dow Jones Indices swapped out three (10%) of them; it dropped Alcoa, Bank of America and Hewlett-Packard, and replaced them with Goldman Sachs, Visa and Nike. This was not a felicitous change in terms of the index’s performance; in the next two weeks, Goldman shares fell 2.2% and Visa dropped 0.4% of its share value. Nike fell 0.6% as well. Goldman’s drop alone cost the Dow 29 points.
Meanwhile, most investors believe that the S&P 500 index is made up of a fixed list of the 500 largest U.S. companies. Not true! The index–and other S&P midcap and smallcap indices–are actually trading stocks onto and off of the list on a fairly regular basis. On September 11, the S&P 500 added Vertex Pharmaceuticals and SAIC, Inc.; this was five days after Delta Air Lines was added after S&P 500 member Bain Capital acquired another member of the club, BMC Software. The index replaced Apollo Group with News Corp on June 20, Zoetis, Inc. replaced First Horizon National Corp on June 14, Kansas City Southern replaced Dean Foods on May 16, Regeneron Pharmaceuticals replaced MetroPCS Communications on April 24, PVH Corp. replaced Big Lots, Inc. on February 7–and that’s all just in the first three quarters of this year. There were 18 additions and deletions in 2012, although some of those were the result of acquisitions and spin-offs.
Does it make sense to compare actively-managed investments with actively-managed benchmarks? Does it make sense to invest in index funds that actually have to change their composition up to 18 times a year? There are no clear answers to these questions. Index funds and ETFs–even actively managed ones–usually show up well in the performance rankings, in part because they can be managed cheaply, in part because they remove some (but not all) of the decision-making and therefore are not likely to follow the herd. But you should know that the performance of the most widely-quoted indices reflects not just movements in the market itself, but changes to the yardstick being used to measure market movements.