Do new index stocks bring better returns?
This article is from the business times
Study on returns of S&P 500 Index stocks shows surprise findings
By TEH HOOI LING
SENIOR CORRESPONDENT
MARKET indices are used as benchmarks for measuring the performance of mainly larger capitalisation companies in various markets.
For example, the S&P 500 Index covers almost all the 500 largest companies ranked by market value which are traded on the New York, American and Nasdaq exchanges. It captures 83 per cent of the market value of stocks traded on these exchanges.
To better reflect the composition of the market as the economy changes over time, indices are continually updated. New companies which meet specified criteria – like market value, earnings, and liquidity – are added, while those which don’t match up are eliminated. Meanwhile, corporate actions like mergers and acquisitions, spin-offs and privatisations also affect the component stocks of an index.
The S&P 500 was first compiled in March 1957. Since then more than 900 new companies have been added to, and a like number deleted from, the index.
For example, companies like Intel, Microsoft and Walmart which didn’t exist when the index was created now constitute a significant part of the index. Meanwhile companies like US Steel, Union Carbide and Eastman Kodak have declined.
In fact, the market value of the S&P 500 companies that have survived from the original 1957 list is only 31 per cent of the 2003 year-end S&P 500′s market value.
Many financial advisers tell their clients to continually upgrade their portfolio because new companies offer investors higher returns than older, fading companies. Their recommendations are supported by the research of McKinsey & Company’s Foster and Kaplan (2001), which reported that the new companies added to the S&P 500 have generated higher returns than the original companies. They stated that ‘without these new firms, the performance of the (S&P 500) index would have been considerably less’.
In a recent study, Jeremy J Siegel, professor of finance at the Wharton School, University of Pennsylvania, and Jeremy D Schwartz, a senior analyst at Wisdom Tree Investments, has disputed that finding.
Surprise results
Their surprise findings showed that the buy-and-hold returns of the 500 companies chosen for the original index have outperformed the returns on the continually updated S&P 500 used by investment professionals to benchmark their performance. Furthermore, this was achieved with lower risk.
And incidentally, the continually updated S&P 500 Index has outperformed the majority of active money managers and mutual funds over time. The original 500 companies contained 425 industrial, 25 railroad and 50 utility companies. In 1976, 40 financial stocks were added, in place of some of the original companies.
To calculate the performance of the original S&P 500 companies, Messrs Siegel and Schwartz formed three portfolios. The first portfolio, the Survivors Portfolio (SP), consists of shares of only the original S&P 500 companies. Shares of other companies received through mergers, spin-offs and privatisations were immediately sold, and the proceeds were invested in the remaining survivor companies in proportion to their market value. At year-end 2003, the SP consisted of 125 original companies. Of those, 94 are still in the S&P 500, 26 are publicly traded companies not in the index, and five are in bankruptcy proceedings.
The second portfolio, the Direct Descendants Portfolio (DDP), consists of shares of companies in the SP plus the shares issued by companies that acquired an original S&P 500 company.
The third portfolio, the Total Descendants Portfolio, includes all companies in the DDP plus all the spin-offs and other stocks distributed by the companies in the DDP. The TDP is identical to the portfolio of a totally passive investor who held all the spin-offs and shares issued from mergers and never sold any stock. In all three, dividends were reinvested in the stock paying the dividend. For each of the portfolio, equal and value weighted returns were calculated.
From the table, you can see that all six of the portfolios of the original S&P 500 stocks outperformed the S&P 500 benchmark, and all had higher Sharpe ratios, used to measure return per unit of risk.
‘These results mean that the 500 companies chosen by S&P’s in 1957 have, on average, outperformed the nearly 1,000 new companies added to the index during the subsequent half century,’ wrote Siegel and Schwartz.
Reducing returns
Among the top performing companies in the original S&P 500 are Royal Dutch Petroleum, Shell Oil, General Electric, IBM, Sears, DuPont, General Motors, AT&T, Philip Morris, Abbot Labs, Bristol-Myers, Pfizer, Coca-Cola, Merck, Pepcico, Kraft, Colgate-Palmolive, HJ Heinz, Wm Wrigley, American Tobacco and Columbia Pictures.
So why does adding new companies actually reduce the return of S&P 500 Index? According to the authors, generally, new stocks are added when there is a lot of hype surrounding them. It was the case in the 1978-90 energy bubble and the 1998-2000 IT and telecoms bubble. Their high prices relative to their fundamentals led to a downward bias to future returns. Also, companies which are added will see a wave of buying from indexers. This will cause their share prices to be inflated even further. Meanwhile, there is a value bias for the original portfolio. Those stocks tend to have low price-to-earnings ratio.
Messrs Siegel and Schwartz thus concluded that updating the S&P 500 to include new companies, although it may increase diversification, is not essential to achieving good returns. Furthermore, the original companies in nine out of the 10 industry sectors actually outperformed the new companies that were subsequently added to the index.
Their study also shows a weak relationship between returns of an industry sector and the relative change in aggregate market value of that sector. Their research thus provides further evidence that it doesn’t pay to buy into the hippest stocks of the day.
I did a quick check with the Straits Times Index (STI). From the existing crop of 49 companies, 29 have a history of at least 10 years. Based on the share price performance alone, a value-weighted portfolio of these 29 companies outperformed the STI by 62 basis points a year in the last 10 years.
Of course, these 29 are the ones which have survived.
If we were to take the portfolio of ST Industrial Index (STII) stocks, as a whole their performance in the last 10 years has been dismal. Companies like General Magnetics, First Link Investments, Intraco and IPC were component stocks then. And all have lost more than 70 per cent of their value in the last decade. Gains in SPC, Singapore Airlines and Yeo Hiap Seng, meanwhile, weren’t enough to make up for the losses.
Perhaps the selection criteria for the then STII could have been better. Of the stocks on the list, less than a handful look particularly exciting as investment prospects today. Thus it was a good thing that the index was revamped and was replaced by the STI in 1998. But a few have been privatised or taken over by others, like Avimo, Omni Industries, Electronic Resources, OUB and Inchcape, while some like Informatics, Lindeves-Jacoberg, Thakral are floundering. But by and large, the large cap stocks on the original STI still look promising. Thus they may be a good place to start for investors planning a long-term buy-and-hold strategy.
Previous articles of this column can be found in volumes I and II of the book ‘Show Me the Money’, available at major bookstores.
The writer is a CFA charterholder. Her e-mail: hooiling@sph.com.sg
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