Flaws in S&P 500 Indexes

[ether]

Interesting read: http://www.joshuakennon.com/sp-500s-dir ... le-secret/

The main points are that what defines the S&P 500 (and all the indexes based on it) are set by a private company that doesn't have the best interest of retail investors in mind, but instead on maximizing fees for investment banks. Main two examples being:

1) Arbitrary rule that all S&P 500 index must be American based companies starting in early 2000's
2) Increase a stocks weight in an index when insiders are selling off the company (Which means indexes buying shares at peak prices) thus reducing overall returns

[IlliniDave]

The SP500 is not designed to be an investment vehicle/portfolio, it's designed to be a metric of the broader large company US market. It was around for decades before anyone tried to replicate it as a mutual fund portfolio (and the first that did were scoffed at, it was called "Bogle's folly").

[ether]

The main issue is that many stock index funds are tied to the S&P 500 these days and passive investing is becomingly increasingly popular. So when S&P 500 rules change it impacts millions of retail investors.

[IlliniDave]

There are several funds that track it, and some are large. There are many more that state it as a benchmark but don't actually track it. The better choice for indexing is a total market fund, then the details of how an index designer puts together an index doesn't matter too much. The weighting does, of course, and people disagree on what's best there. I'm good with market cap weighting because of its efficiency. Others often are not.

It is good to beware of how indexes are constructed and how they change. Personally I don't bother though.

[BlueNote]

I don't understand why people still use that index when there are indexes that are much better at manifesting the spirit of index investing. It used to be the DJIA that everyone referred to but it is even more flawed then the SP500. For the US market I currently prefer the CRSP US Total Market Index because it has virtually 100% cap weighted representation of the entire tradable US stock market. However for my US investments I invest in a world index ( FTSE Global All Cap ex Canada China A Inclusion Index) that takes out my home country. End of the day the S&P 500 is probably going to closely track the CRSP index anyways so the differences are only going to be big over very long periods of time when compounding really matters.

[slowtraveler]

I love that article.

"Increase a stocks weight in an index when insiders are selling off the company (Which means indexes buying shares at peak prices) thus reducing overall returns"- I believe this is float-adjustment and only makes sense because there are so many people buying into indexes. I heard it makes sense for the MF but not for the individual investor. Hence, my interest in building a private index fund to replace the MF index in my portfolio. The benefits of indexing without the costs in performance resulting from Wallstreet's changes in methodology.

I'll be binging on some Bogle and Siegel once school is out to learn more about how exactly they recommend implementing a private index fund but for most people, a public index fund is enough. Yeah, it has limitations but as Kennon & Bogle & Buffet & Munger say-it'll likely perform good enough and will outperform most active managers after fees.

I think this is a larger issue here since many of us will have 6 & 7 figure net worths where the benefits of finding a way around these limitations outweigh the costs associated with implementing them.