True to Label?
When an investor decides to track an index fund like the S&P 500 they might reasonably assume that they are investing in the largest 500 stocks in the US market. The truth is that investors in S&P 500 index funds own only a sample of the 500 US large cap stocks. The investment committee administering that noted benchmark actively selects not only which stocks belong in the index but when to include them. And that process can take time.
Here’s an example: In 2023, funds that tracked the S&P 500 purchased 12 new stocks, including household names like ride-sharing company Uber and activewear maker Lululemon Athletica. Given these two stocks had already been among the top 500 largest stocks for months before their inclusion in the index, passive investors might have been surprised to learn that they did not already own them.
That had consequences, because during their waiting periods between entering the top 500 and being admitted to the S&P 500 by the index gatekeepers, both those stocks had outperformed the overall index. And this isn’t a one-off. In fact, the record shows the average wait time between companies reaching the big league of 500 and being recognised for it is 28 months, or more than two years.
And, of course, individual waits can be much longer than the average. For instance, cybersecurity company Palo Alto Networks waited 97 months, or just over eight years, from the time it first entered the ranks of the 500 biggest companies in the US until it finally was allowed into the index in June 2023.
As to the reasons these delays occur we have written about before here, but in short it comes down the long list of eligibility requirements set by the index selection committee.
There are a number of reasons this matters for investors. First, it’s a reminder that indexes are just a representation of the market, not the market itself. Second, the creation and maintenance of an index entails numerous active decisions. In practice, these choices have important implications both for characteristics and for returns.
Ultimately, investors should consider whether all the active decisions made by index providers align with and are consistent with their own objectives, because the record shows that what’s on the label isn’t always a reflection of reality.
Waiting Room: S&P 500 Additions in 2023
This article originally appeared in Short N Sweet, a newsletter for Dimensional clients.
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