Taking Stock of the S&P 500 Index

Morningstar

Since 2005, equity investors have put nearly $1 trillion into passive mutual funds and exchange-traded funds while pulling $300 billion out of active funds. Although the Dow Jones Industrial Average may be older and more widely cited, the S&P 500 Index's market-cap weighting makes it closer to the ideal "market portfolio" envisioned in the efficient-market hypothesis. The S&P 500 has become the most popular index that mutual funds and ETFs track. There are 54 distinct mutual funds indexed to the S&P 500 and three ETFs. Of these, only a handful can justify their existence.

An S&P 500 Index fund can serve as an effective building block for exposure to United States equities. The index contains with 500 of the largest publicly listed U.S. companies. And for the most part, it has lived up to the expectations of the efficient-market hypothesis, proving to be extremely difficult for active managers to beat consistently after fees.

However, the S&P 500 lacks exposure to many mid-cap and all small- and micro-cap stocks. Although small in size, smaller-cap stocks historically have helped boost the performance of total-market indexes relative to the S&P 500 Index, with only a slight increase in risk. In addition, the S&P 500 is not as mechanically constructed as some other indexes because the committee that oversees it has some flexibility over index changes. For investors looking for diversified exposure to U.S. stocks, a low-cost S&P 500 Index fund is a worthy candidate.

Investment Options
While there are a lot of great options for exposure to the S&P 500 Index, there are also a lot of bad ones. There are 57 unique funds tracking the S&P 500 Index, and a total of 149 share classes with $737 billion in assets. But 90% of those assets are in just 15 share classes. In 2013, those 15 share classes had an average return of 32.28%, just 0.11% shy of the index. But there are also 54 share classes with less than $100 million and an average return of only 31.15%.

While a lot of these smaller index funds carry higher expense ratios, they still might be appropriate for investors with a limited set of options. For example, employees limited to choices within a 401(K) plan that is littered with high-priced funds may still prefer a moderately priced index fund. The lowest-cost S&P 500 Index funds tend to be institutional share classes, which require large investment minimums. But in between the low-cost and midpriced institutional share classes, there are a lot of good choices.

Two funds with Morningstar Analyst Ratings of Gold, Fidelity Spartan 500 Index (FUSVX) andVanguard 500 Index (VFIAX), charge 0.05% for investors who meet the $10,000 investment minimum. Silver-rated Schwab S&P 500 Index (SWPPX) charges 0.09% with only a $100 investment minimum. Silver-rated DFA US Large Company (DFUSX) charges 0.08% but must be purchased through an approved financial advisor. ETFs require no investment minimum beyond the price of one share. iShares Core S&P 500 (IVV) charges 0.07%, while the largest S&P 500 Index fund, SPDR S&P 500 (SPY), charges 0.09%. Vanguard S&P 500 ETF (VOO) charges 0.05% and is technically a separate share class of the Vanguard 500 Index mutual fund.

Each of these closely mirrored the performance of the index and each other. However, two funds deserve further mention. Among the ETFs, SPDR S&P 500 uses the older unit-investment-trust legal structure, which prevents it from reinvesting dividends, holding securities that are not in the index (such as futures), or lending securities. DFA allows itself slightly more flexibility when replicating the index. Instead of ramming through trades for index changes on the exact date that they occur, which may create higher than necessary transaction cost, DFA trades more patiently. While this does result in slightly higher tracking error, it also has allowed the fund to earn back its fee.

The Market Isn't Cheap, but Perhaps Not as Rich as CAPE Crusaders Suggest
Finishing the year at 1,848, the S&P 500 Index had a 32.39% total return in 2013. At this point, the market appears fully valued and more expensive than it has been for the past several years. Based on Morningstar equity analysts' fair value assessments of the index's underlying constituents, the S&P 500 is trading at a price/fair value multiple of 1.03, or slightly above fair value.

While the market no longer looks cheap, it is not necessarily expensive, either. Bears like to point out that the cyclically adjusted price/earnings (CAPE) ratio is at 25.5 times, well above its post-World War II average of about 18.4. The CAPE is a P/E ratio that uses trailing 10-year earnings to smooth out cyclicality. Thus, at a CAPE of 25.5, the market would appear overvalued. But there are several reasons why a historical comparison based on the P/E ratio alone may overstate the market's current valuation.

First of all, a P/E ratio measures the current market value of a company's equity to its earnings. If a company has excess cash on the balance sheet, that cash is implicitly included in the price you pay for the stock. But since it is excess cash, it is not used to generate earnings. Thus, the numerator of the P/E ratio gets inflated by cash while the denominator does not. Another way the effect of cash on stock prices can be seen is when companies pay dividends. The share price drops by the amount of the dividend. Since the financial crisis, cash on the balance sheets of nonfinancial companies has reached record highs, doubling to about $1.4 trillion, or $158 per index unit. The record level of cash makes historical comparisons using the P/E ratio less meaningful. If we assume all of this growth in cash or half of the current amount is excess cash that is unnecessary to run the business and generate current earnings, then the level less cash for the S&P 500 would be closer to 1,769, resulting in a CAPE of 24.5 rather than 25.5 without deducting the excess cash. Accounting for cash shaves almost a full point off the CAPE.

A second reason why a comparison of the current CAPE to its historical average is less meaningful: The level of interest rates has changed. Despite its simplicity, the P/E ratio has a solid theoretical underpinning in dividend discount and free cash flow discount models. These models suggest that stock prices reflect the sum of all future cash flows discounted at the appropriate rate of interest. Lower interest rates, in theory, should result in higher prices, and that is exactly what we find in the data. Since 1946, when the real 10-year Treasury rate has been between 1% and 4%, the average CAPE has been 20.87. Lower and even negative real rates, such as in the inflationary 1970s, corresponded to a lower CAPE. Periods of higher real interest rates, such as in the early and mid-1980s, also correspond to a lower CAPE. The current inflation rate of about 1.20% and the 10-year Treasury rate of around 3.00% translate into a real rate of about 1.80%, suggesting that it is not unreasonable for the CAPE to be above its long-term average.




Sources: Robert Shiller and author's calculations.

Michael Rawson, CFA does not own shares in any of the securities mentioned above.

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