03/24/97 WHY IT'S SO TOUGH TO BEAT THE S&P

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WHY IT'S SO TOUGH TO BEAT THE S&P

The whole world watches the Dow Jones industrial average, but for investment managers, beating the Dow will not necessarily make them heroes. Whether they collect a fat bonus or nothing at all depends on their performance vs. the Standard & Poor's 500 stock index.
The S&P index first gained sway over the markets back in the 1970s, when pension-fund managers sought a broad-based index against which to judge their performance. Though much else on Wall Street has changed in the years since, the S&P 500 has persisted as the market's principal benchmark--and an often difficult one to beat at that. For the past three years, in fact, most institutional money managers and mutual-fund managers have failed to do so. Only 22% of U.S. diversified equity funds topped the index in 1996, for example.
As a consequence, frustrated investors have poured an estimated $475 billion into S&P index funds. Since the end of 1994 alone, the assets of the largest index mutual fund, the Vanguard Index 500 Fund, have risen 276% (chart). Because such funds in turn buy the same index stocks, the effect is perverse: Those purchases drive prices higher still, making the index even harder to beat.
The index itself was born in 1957, when the number of stocks in the S&P Composite was increased from 416. In 1976, the configuration was codified: 400 industrial stocks, 40 utilities, 40 financial, and 20 transportation, though the guidelines have since been relaxed to reflect the market. It was also around then that the S&P gained prominence, in reaction to a new federal law that required pension administrators and consultants to monitor money managers' performance. The Dow industrials, with just 30 stocks, was too narrow. The S&P, which then accounted for some 95% of the market's capitalization, seemed the right choice.
WORK IN PROGRESS. If the S&P 500 has since become a Wall Street institution, its composition is always in flux. In 1995 and 1996, 57 names were added, mainly to replace acquired companies. This year has seen two switches: Insurance broker Alexander & Alexander Services was replaced by insurer Conseco, while Boatmen's Bancshares gave way to HealthSouth. The index keepers at S&P determined that the health-care company would make the index truer to the makeup of the market.
In choosing a replacement, S&P takes into consideration market value, industry category, and a prospect's financial condition. ''S&P has done a good job of making sure the index reflected the decline in basic manufacturing and the rise of technology,'' says H. Vernon Winters, chief investment officer at Mellon Private Capital Management. ''When they choose new companies, they pick better, more successful companies, and that gives the index more of a growth orientation.''
The other major consideration for choosing companies for the index is liquidity. If investors can't buy or sell shares easily, S&P doesn't want it. That's why UAL Corp., despite a $38 billion market value, is not in the index. Some 55% of its shares are locked in an employee stock-ownership plan.
What makes the index so tough to beat? It's a capitalization-weighted index, today accounting for 69% of the market value of the $8.1 trillion U.S. equity market. The larger the market cap of a company, the more it counts in the index. The 10 largest stocks drive 19% of the index, and the 50 biggest, nearly half. This makes the index sensitive to the fortunes of these megacompanies, and for the past few years, at least, they have been on a roll. The globalization of business plays right to their strengths. Corporations such as General Electric Co. and Coca-Cola Co. have the products, expertise, and resources to exploit those opportunities.
Another reason why money managers are underperforming the index is that they tend to invest in companies that have, on average, much smaller market caps than those in the S&P. Although historically, smaller stocks have delivered higher returns, over the past three years that hasn't been the case. Even when managers invest in large-cap stocks, they ''equal-weight'' their portfolios. So if the larger companies outperform the smaller, these managers don't always get the same performance as the index funds.
Because movement in the S&P 500 is so influenced by the largest companies, many investment managers would prefer to be judged by other measures. ''The best benchmark is one that emulates the pond where the manager is fishing,'' says Ronald D. Peyton, president of Callan Associates Inc., an investment consulting firm that can draw on some 600 indexes. Still, Peyton concedes, what clients of these managers still want to know at the end of the day is: ''Did we beat the S&P?''
By Jeffrey M. Laderman in New York

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