When it comes to indexes, there is life beyond the Standard & Poor’s 500. And the Dow Jones industrial average, for that matter.
Indexes, those measures of stock- and bond-market performance that makes it simple to monitor whether your investment is keeping up with the market, are more complicated than the over-in-a-second mentions on the nightly news suggest.
Here are 10 points to keep in mind about indexes:
1. While investors have intense debates over which index is the best yardstick of the market, it doesn’t appear to make much difference in the long run.
From 1973 to the present, the Dow, S&P 500 and the Wilshire 5000 index, which tracks the entire U.S. market, all generated about the same average yearly returns.
But for individual investors trying to determine whether they’re ahead or behind at the end of the day, there are other points to consider.
2. Size matters. So does style. If you’re comparing returns in your mutual fund to the S&P 500, you may be shortchanging the fund manager.
It’s not fair to stack the performance of a small-company growth fund against the S&P, which measures big companies. Instead, try the Russell 2000 or Wilshire 4500 indexes, which both measure small-company stocks.
Don’t overlook style either. If you own a bargain-hunting value fund such as Vanguard Windsor, compare it to the S&P/BARRA Value Index. For a go-go big-company growth fund such as Janus Twenty, stick with the S&P/BARRA Growth Index.
For a measure of the entire market, look to the Wilshire 5000, which includes the more than 7,000 publicly traded U.S. companies.
3) Sometimes an index is more like an actively managed mutual fund than a passive market measure. A committee determines the stocks that make up the S&P 500 and their reasons for including one stock and not another can be subjective. That has led some to complain that S&P is picking stocks the way fund managers do.
The Russell and Wilshire indexes, on the other hand, use strict criteria based on objective numbers.
4) The math matters. The Dow is a price-weighted index of 30 stocks, meaning changes in the value of high-priced stocks affect the value of the Dow more than changes in low-priced ones do.
The S&P, on the other hand, is weighted according to the market capitalization — shares outstanding times price — of each stock in it.
This mathematical difference creates some strange outcomes, said Charles Carlson, an editor of investing newsletters and author of “The Individual Investor Revolution.” Since Disney’s market cap is about eight times that of Union Carbide’s, Disney’s weight in the S&P — and its influence on the index — is eight times that of Union Carbide’s. In the Dow, however, Union Carbide has roughly twice the weight of Disney because the price of Union Carbide’s stock is almost twice that of Disney’s.
This makes the Dow kind of a goofy index.
“Historically, the reason for the price weighting was that the Dow was created in 1896, when cap-weighting would have been too cumbersome” for Charles Dow to calculate by hand, said Gus Sauter, head of Vanguard Group’s index funds.
5) All indexes are not created alike. The Dow Jones Internet Index shows those high-flying net stocks up 44.24 percent so far this year. So how can the Goldman Sachs Internet Index show just a 33 percent gain and thestreet.com Net Index, or DOT, a 37 percent gain?
Think of each index like a party whose success depends on which companies the creators of the index invite and how they mix those guests together in a mathematical formula.
The Dow index is the broadest of the three, with 40 stocks. Its life of the party was Ameritrade, up 376 percent this year. That stock isn’t in the DOT, which instead includes online broker ETrade, and whose top-performer, CMGI Inc., is up 262 percent.
Goldman’s index is the least representative of the three because its creators weight the index based on the size of the companies in it. That means that the two biggest members, America Online and Yahoo, account for 50 percent of the index’s performance. How’s that for overbearing party guests?
6) Be careful with industry indexes, which can be narrow. The S&P Restaurants Index has four companies in it, and McDonald’s accounts for 80 percent of the weighting. You might be better off to compare Wendy’s directly to McDonald’s or Bob Evans against Cooker Restaurant Corp., which operates restaurants in the South and Midwest.
7) The Bill Gates factor. Often, executives and insiders own big chunks of their companies. Some indexes, like the Russell indexes, reflect this. Others, like the S&P indexes, don’t.
That means companies such as Microsoft in theory have more influence on an index than they do on the market, where the 501 million shares owned by Gates, which is 19.8 percent of all shares, are not for sale.
8) Indexes change. The Frank Russell Co., for example, changes the companies in its index every year to get rid of companies too small or too big to remain in the 2000 index and add those that have increased to the proper size.
That has big implications this year, when high-flying Internet stocks such as ETrade Group graduate from the Russell. Without those Internet companies, the Russell would have lost 8.4 percent in the first quarter instead of the 5.4 percent it actually did lose.
Keep the Internet effect in mind when evaluating the performance of your small-company stock or fund. If a fund manager avoids Internet stocks because they don’t have earnings, and you agree with that philosophy, do more analysis before concluding that your manager is lagging.
9) Who’s the smallest of them all? Not the Russell 2000. The Russell 2000 index is the 2,000 smallest companies of the 3,000 largest companies in the U.S. market. Russell does it this way because the remaining small companies are so tiny that fund managers usually can’t buy them.
But Burton Malkiel, Princeton University professor and author of the newly revised “A Random Walk Down Wall Street” argues that the Wilshire 4500 is a more comprehensive small-cap benchmark because it includes the 6,500 smallest stocks in the U.S. market.
10) Indexes aren’t the only yardsticks out there. Lipper Inc. and Morningstar Inc. both compare individual funds to all funds with the same investment objective. The funds are then ranked by performance within their peer groups.
“We think a fund should be compared to other funds attempting to do similar things,” said Lipper chairman A. Michael Lipper. “An index can wind up with too much in a particular sector that a prudent manager would not permit in a portfolio that’s meant to be diversified.”
