On a day when the Nasdaq reached yet another all-time high, the most astounding move was made by Yahoo, which leapt 24 percent, adding more than $17 billion to its market capitalization. Yahoo is joining the S&P 500 tomorrow (making it only the second Internet company, after AOL, to do so), and in the week since its addition to the index was announced its share price has risen almost 150 points.
The situation, at least today, boiled down to too much demand chasing too little supply. Index funds, which track the S&P directly, had to buy shares of Yahoo in proportion to its market cap, since the S&P is market-cap weighted. And since there are plenty of mutual fund managers out there who try to mimic the S&P–while charging significantly more in fees than an index fund–there was other institutional money chasing Yahoo as well. And as the company’s shares became more expensive, funds had to buy more of them (because of the market-cap weighting). The result was a virtuous circle for sellers and a truly vicious one for buyers.
Still, the picture seems a bit more complicated than this, because the average trade in Yahoo today was just 503 shares. Needless to say, most institutions are not buying stock in 500-share lots, so that means that a great deal of the action today was driven by individual investors and, most likely, day traders hoping to ride the stock’s momentum and to get out before the eventual fall. Today was, in that sense, a moment when this decade’s crucial stock-market trends–indexing, momentum investing, individual investing, and the Internet–converged to make Yahoo investors very happy indeed.
It’s almost certain that the stock will fall in days to come, but its ride up has been so furious, and the company is such a good one, that it would be surprising if the tumble were too precipitous. In any case, the most important thing about Yahoo’s addition to the S&P is not the effect on its stock price. Instead, it’s the way that addition drives home an often-overlooked but nonetheless crucial fact about the S&P 500, that it is as actively managed as any mutual fund.
This point was first made, as far as I can tell, by Bill Miller, the brilliant fund manager of Legg Mason Value Trust, in a letter to his investors earlier this year. Index funds, Miller pointed out, are passively managed, which is to say that they simply duplicate the S&P 500 in order to replicate the performance of the “market.” But the S&P 500 itself is added to and subtracted from in an attempt to make the index look as much like the stock market, and the economy as a whole, as possible.
If this is the case, why is it so difficult for fund managers to beat index funds based on the S&P? There seem to be two reasons. The first, and most obvious, is that index funds have minuscule fees and very low transaction costs. The second, though, is that the fact that the S&P is weighted by market capitalization means that it manages money–and therefore investments–in almost a textbook fashion. As companies grow more successful, and more expensive, they take up a larger percentage of the index, and as they grow less successful, and cheaper, they take up a smaller percentage. In other words, the index effectively allows its winners to run and its losers to dwindle.
You’ll often hear fund managers say it’s unfair to benchmark them against the S&P because it does things like add Yahoo and take out Laidlaw (the company that will be booted tomorrow). Assuming that Yahoo, even with its recent run-up, will do better over the next five years than Laidlaw, then the S&P will do better than it would otherwise have done. (Significantly better, in fact, given the size of Yahoo’s market capitalization.) But the S&P’s approach to investing–add dominant companies the market has already rewarded–and to money management is easily replicable. It’s a measure of how addicted to trading fund managers have become that instead of replicating that approach, they prefer to complain about it.