Should You Sell Your S&P 500 Index Fund?

(MoneyWatch)  Because I fielded so many questions about it, I wanted to weigh in on my friend and colleague Allan Roth's post last week on S&P 500 index funds. As I typically do, I agree wholeheartedly with Allan's analysis. S&P 500 funds do not provide investors with exposure to the entire domestic stock market -- it's a large-cap index, composed of 500 of the largest U.S. corporations. And the index is subject to front running, in which investors bid up the price of stocks that are going to be added to the S&P 500.

Given those facts, investors might be wondering if it's wise for them to continue to hold an S&P 500 index fund. My answer: unequivocally yes.

The investors I spoke with fell into two categories: long-term owners of a 500 index fund who had built up significant capital gains; and those who owned a 500 index fund within their 401(k) plan. If you're in the first category, it makes little sense to sell your 500 index fund and incur taxable gains in order to move into a total stock market index fund. If you're in the latter category, with no index funds offered beyond one that tracks the S&P 500, such a fund remains a far superior choice to the handful of actively managed alternatives.

In either case, these investors can supplement their S&P 500 index fund investment with a small-cap index fund. Allocating 80 percent of your domestic stock allocation to an S&P 500 index fund and 20 percent to a small-cap index fund allows you, in effect, to create your own total stock market index fund.

But even given the caveats about the S&P 500 that Allan highlighted, a curious fact remains: history has demonstrated that they haven't mattered much at all. Since its start in 1970, the Dow Jones Total Stock Market index has provided an annual return of 10.2 percent through year-end 2009. In that same period, the S&P 500 index has earned 10 percent annually.

Using Ken French's data, we can go even further back. From 1927 through 2008, Professor French's series for the total stock market has returned 9.3 percent annually, slightly trailing the S&P 500 index's 9.6 percent return for that period.

Yes, the returns of the 500 index and the total stock market have differed from year to year -- at times by rather large amounts. But over time, as market returns ebb and flow, those differences have almost entirely canceled each other out.

Despite the flaws in its construction and its lack of small-cap exposure, the S&P 500 has proven to be remarkably consistent relative its broader total stock market cousin over the long term, and it has more than held its own versus active managers, to boot.

Yes, 500 index fund investors will have to seek their small-cap exposure elsewhere, but history has demonstrated that they have little reason to fear being short-changed relative to the broader market.