Tech stocks. You can love them or you can loathe them, but if you invest in mutual funds based on the Standard & Poor’s 500-stock index, you certainly own a bunch of them.
That’s why January’s tech-stock swoon and the nosebleed valuations sported by most big-tech names have implications far beyond the adrenaline-pumped world of day traders and Internet initial public offerings. Tech stocks now make up a record 30 percent of the S&P 500, up from about 13 percent just three years ago, while the trailing price-to-earnings ratio of the index has risen to 33.4–tying a record set at the end of 1998–from 19.1, according to Standard & Poor’s.
But don’t go blaming the bureaucrats at S&P who pick the stocks for the index. The index is about as tech heavy and expensive as the overall market. So the question for investors is not whether to buy the index, but whether to be invested in the overall U.S. stock market. If the valuations are too scary, an S&P 500 index fund isn’t a haven.
The main culprit for the changes in the index has been the stunning rally in big technology stocks such as Microsoft Corp. and Intel Corp. these past few years. “There’s no question technology stocks are carrying very high valuations,” says Gus Sauter, who runs Vanguard Group’s hugely popular index funds. “It does mean there is probably more risk.”
Added to that risk is concentration-heavy concentration. Right now, the S&P 500’s biggest members make up a larger portion of the index than at any time since the early 1970s, when the so-called Nifty 50 stocks dominated the market. Today’s top-10 stocks, led by Microsoft, Intel, General Electric Co. and Cisco Systems Inc., account for nearly a quarter of the index’s value, and its performance, for better or for worse.
Last year, the 10 biggest companies in the index returned 38.8 percent on average, compared with just 4.4 percent for the bottom 200 companies, according to the Leuthold Group, a stock-market research firm in Minneapolis. And if you removed all the tech stocks from the S&P 500, its return would have fallen to 3.1 percent last year from 21 percent.
The irony of the situation is that the strong performance of the top-10 stocks creates a virtuous circle. Stocks such as Microsoft do well, pushing the index higher. Investors chase that performance by buying index funds, which, in turn, have to buy more Microsoft.
The worry among analysts is that investors, instead of buying index funds for the usual reasons–low expenses and turnover and average returns–have been seeking performance. “I think a lot of their growth has been the hot-fund-of-the-month kind of growth,” says David Blitzer, S&P’s chief investment strategist and chairman of the S&P index committee.
Vanguard 500 Index Fund, with about $104 billion in assets, has been the best-selling fund every year for the past four years, although a handful of turbo-charged tech-heavy funds eclipsed it in November, according to the latest figures from Financial Research Corp. in Boston. The Vanguard fund–launched in August 1976 as the first index mutual fund–began the decade with just $2 billion in assets, and has doubled in size during the past two years.
But what is hot inevitably goes cold, meaning that if tech stocks tumble and the S&P 500 goes with them, investors may start looking for the next big thing, forcing the S&P 500 funds to dump stocks to meet redemptions. With these portfolios holding virtually no cash, this can bring more pain to index-fund investors than most people realize. Mandated to match the index, the funds would sell stocks across the board to stay aligned with the S&P 500. And given how much hot money is believed to have poured into S&P 500 funds during the past couple of years, the redemptions could be unusually heavy. With about $1 trillion tracking the index, matters could quickly go from bad to worse.
Anyone who doubts the power index funds exert on the market need only look back to Dec. 7, when Internet high-flier Yahoo! Inc. was added to the index. As index-fund managers swallowed hard and bought a stock that had soared $68 the week before to $280 (and it was already considered pricey before that runup), the stock soared another $68. “I don’t second-guess the market,” says Vanguard’s Sauter. “You grin and you buy it.”
Sauter bought 4 million Yahoo shares that day for Vanguard’s S&P 500 fund, though he was able to cut his costs a bit by picking up the shares that Vanguard Extended Market Fund, which invests in non-S&P 500 stocks, had to dump.
It is situations like this that worry market bears. Consider this research by the Leuthold Group. The S&P 500’s trailing price/earnings ratio at the beginning of the year of 33.4 compares with a historical median of 17.3. If the index were to return to the historical median, that would mean a roughly 50 percent drop, not something that most index-fund investors probably could stomach. Even if just the tech stocks in the index fell by half, which would still leave them richly valued, the S&P 500 would tumble 15 percent, according to Salomon Smith Barney.
Another surprise for most investors: The companies in the index have changed considerably over the past few years. According to S&P, there were a record 91 changes in 1998 and 1999, driven largely by mergers and acquisitions. That means index funds have had to dump stocks like Chrysler Corp., because DaimlerChrysler AG is now considered a German company. “When you have lots of changes, you do have to do more trading, so you incur more trading costs,” Sauter says.
(Sauter, by the way, has been able to run his fund so efficiently, including making savvy bets on futures, that he has been able to beat the index, though by an infinitesimal margin, in each of the past two years.)
Of course, no one sector dominates the market forever. The companies that dominated the index back at the end of the 1960s–the Nifty 50 stocks such as International Business Machines Corp., AT&T Corp. and General Motors Corp.–lost an average of 1.1 percent a year over the succeeding decade. At the end of the ’70s, six of the top-10 names in the index were oil companies. Today, just one oil company, Exxon Mobil Corp., ranks in the top 10. And at the start of the ’90s, arguably the decade of technology, the top 10 was bereft of tech companies, with the exception of IBM.
But analysts point out that the S&P 500, which represents about 80 percent of the stock market, basically reflects the changes that have occurred in the overall market, and, to some extent, the economy.
“If tech stocks are going to drop, sure the S&P is going to drop,” says David Stein, managing director and chief investment officer at Parametric Portfolio Associates, which manages $4.1 billion in mostly customized index funds. “But the whole market is going to drop, too.”
