The Poor Standard of Standard & Poor's

How the S&P 500's bad bubble-stock picks have cost investors billions.
By Daniel Gross Posted Thursday, Aug. 1, 2002, at 9:55 AM PT

For decades, investors have regarded the highly diversified Standard & Poor's 500 as a safe place in which to plow long-term investments. For most of the '90s, Americans were hectored to invest their money in S&P 500 index funds. Champions of the S&P 500 boasted incessantly about how S&P index funds crushed most mutual funds and stock pickers, all while charging lower management fees. But in the past two years, the safe S&P 500 has proved to be even more dangerous than the rest of the market. While the Dow is off 26.6 percent from its 2000 peak, the S&P 500 is off a whopping 40.6 percent.

The index is one of the more unlikely villains of the bubble. Despite perceptions, the index is not a passive investment vehicle. Instead, S&P is constantly choosing new stocks and booting old ones. And in the past few years, S&P's modus operandi—which receives surprisingly little scrutiny—led it, essentially, to recommend that investors buy highly speculative companies at or near their tops.

Standard & Poor's traces its roots to 1860, when Henry Varnum Poor, author of the definitive History of Railroads and Canals in the United States, started supplying financial data to investors. His company began to rate bonds in 1916 and merged with Standard Statistics in 1941 to form S&P. Since 1966, it has been part of the McGraw Hill empire, which also includes Business Week.

S&P has compiled an index of 500 leading companies in critical industries around the world since 1957. (Today, it includes only U.S. companies.) And while it typically doesn't get as much press as the Nasdaq or the Dow, the S&P 500 is far more important than either. Because of its breadth and diversification, the S&P 500 is the crucial benchmark for professional investors. Investments by insurance companies, pension funds, college savings funds run by states, and public employee pension funds are either invested in the S&P 500 companies or mimic its makeup closely. "The S&P 500 is used by 97 percent of U.S. money managers and pension plan sponsors," S&P's Web site proudly notes. "More than $1 trillion is indexed to the S&P 500." (That sum is almost certainly lower now.) About 8 percent of the shares of every S&P 500 stock are held by index funds. As a result, S&P's eight-person Index Committee, which selects the companies that enter and leave the S&P 500, is a far more influential stock picker than Warren Buffett or Fidelity manager Peter Lynch.

When a company merges with another index company, or is acquired by a foreign concern, or files for Chapter 11, the S&P committee automatically deletes it. And some companies simply wither away to the point where the committee—which remains anonymous to forestall lobbying—determines them to be too insignificant to merit inclusion.

Between 1990 and 1994, the committee made an average of about 13 changes each year. But with the surge of merger and acquisition activity in the late 1990s, the need for deletions rose. Between 1996 and 2000, the committee changed an average of 40 companies each year. In 2000, a record 58 changes occurred.

The Index Committee, which meets regularly to evaluate potential targets for inclusion, is guided by several long-standing criteria. Companies added are supposed to be representative of the American economy. They should have market capitalizations of about $4 billion or more and should have the largest market values in their sectors. They must also show four consecutive quarters of profits. The committee also uses new additions to ensure that the index remains representative of a highly dynamic economy. If a health-care company leaves, it is generally replaced by a health-care company. But if a company in a declining industry leaves—say a steel manufacturer—the committee might choose to replace it with a company in a rapidly growing industry, like software or telecommunications.

It's easy to see how the standards, which had generally served the index well, were affected by the bubble. Historically, company and industry market capitalizations have been highly correlated with their commensurate roles in the American economy. But that relationship went wildly out of whack in the late 1990s, as companies with relatively small revenues—Yahoo!, Amazon.com, Qualcomm, etc.—became worth far more than giant companies like General Motors and Sears. Suddenly needing to fill a large number of openings, the committee turned to these initiates.

By and large, dot-coms didn't make the S&P 500, largely because they couldn't report profits. But in 1998 and 1999, telecommunications, software, and fiber-optic companies started to trickle in; in 2000, that trickle became a flood.

AOL was arguably the first New Economy stock granted entree into the S&P 500. It entered at the close of 1998, replacing Venator, the parent company of Foot Locker. Network Appliances entered on June 24, 1999, followed soon after by Qualcomm on July 21, Global Crossing on Sept. 28, and Yahoo! on Dec. 7. The tech-tilted makeover accelerated throughout 2000.

The problem was not that these companies were added—it was clear that they represented an important part of the economy—but when they were added. S&P essentially took many of these speculative companies at or near their tops. When Yahoo! came in, it traded at an astronomical 228 (it's now at 13); Qualcomm traded at 159.75 when it was initiated into the club, and now it trades at 27.

S&P also contributed to the frothiness surrounding these stocks. When S&P announced an addition, it became clear that every public fund that uses the S&P 500 benchmark would have to buy that stock on the date of its inclusion. Guess what that did to the fortunate stocks?

On the day Yahoo! joined the S&P 500, it rose 67 points. And in the week between the announcement and the actual inclusion, Yahoo! rose 136 points, or 64 percent. According to a 2000 study by Salomon Smith Barney, stocks selected for inclusion outperformed the S&P 500 by 7.7 percent in the period between the announcement and the inclusion. The net effect: S&P 500 mutual funds—that is, you—effectively bought these new stocks at artificially inflated prices.

Some of the moves the committee made in 2000 turned out to be enormously bad for S&P investors, adding volatile, incredibly overpriced stocks to the index. On Jan. 28, 2000, Consolidated Natural Gas was replaced by Conexant—then an $88 stock, now a $2 stock. On March 31, auto-parts company Pep Boys was replaced by Veritas Software. On May 4, out went Reynolds Metals and CBS, in came Sapient (a $102 stock) and Siebel Systems. On July 26, JDS Uniphase subbed in for Rite Aid. And on Nov. 3, PaineWebber was swapped for Broadvision. Of the 58 stocks entering the index in 2000, 24 were Nasdaq stocks.

Joining the S&P 500 conferred a greater legitimacy on the companies and brought in a whole new class of institutional buyers who, by virtue of their mandate to follow the S&P 500, had to own the newly selected stocks. By virtue of their mandate to follow the S&P 500, they also had to hold them all the way down.

Throughout 2000 and 2001 many of the multibillion-dollar new initiates plummeted and were unceremoniously ejected from the index. Sapient, for example, was booted out after less than two years, having lost 98.4 percent of its value. Broadvision, worth $23 billion at its peak (it's now worth just $98 million), got axed after just 10 months. Conexant got disconnected last June, 30 months after its inclusion.

Investors who plowed funds into the S&P 500 thinking they were getting a conservative barometer have been sorely disappointed. Sure, the S&P 500's performance hasn't been as abysmal as the Nasdaq's—off 74 percent from its 2000 peak. But because the S&P 500 dictates the investments of millions of investors, its decline has been far more destructive.