The Case Against S&P 500 Index Funds

(MoneyWatch)  If you've read me before, you know that I'm an avid indexer when it comes to investing in equities. I started my index investing over two decades ago with S&P 500 index funds. These days, however, I no longer use them or recommend them. While they were the best thing around when John Bogle and Vanguard introduced this index fund to the general public in 1976, S&P 500 index funds now have two major flaws.

Flaw #1: Doesn't own the entire US stock market
S&P 500 index funds essentially own the largest 500 U.S. based companies. Standard and Poor's decides which 500 companies comprise this index and which ones are booted out. The problem this presents is that it leaves out thousands of smaller U.S. companies that make up a much broader index known as the Wilshire 5000. The Wilshire 5000 now contains over 5,000 individual companies. Granted the S&P 500 comprises about 80 percent of the Wilshire 5000 market capitalization, but it leaves the investor unexposed to the smaller and mid-sized companies that, in the long run, tend to outperform the S&P 500.

Flaw #2: The "Google Effect"
It also suffers from what I call the Google effect. On March 23, 2006, Standard & Poor's announced Google was being admitted to the S&P 500 index. It made the announcement after the stock market had closed that day. Now, just because the stock market is closed doesn't mean people can't trade stocks. Thanks to a Wall Street invention called after-hours trading, it's possible to buy and sell stocks after the market closes. And in after-hours trading, Google went up a whopping 7.3 percent that night. That's because investors knew that all of the many large S&P 500 index funds had to go out and buy Google pronto. Demand for the stock drove the price higher.

Thus, it's reasonable to assume that any new entrant to the S&P 500 index comes at an inflated price, since the S&P 500 index fund will buy only after the price has gone up. Conversely, any company being booted from the S&P 500 index will likely suffer a price decline before the S&P 500 index fund dumps it. It's ironic that the popularity of John Bogle's S&P 500 fund has created this flaw.

A better way to index
The simple solution is to own a total U.S. stock index fund for your domestic equity investing. This avoids both of the flaws noted above. John Bogle introduced the Vanguard Total Market index Fund (VTSMX) in 1992, and others are available through Fidelity, iShares, State Street, and Schwab.

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