The Death of Indexing - Navallier

[Sniper]

THE DEATH OF INDEXING

This year is shaping up to be remembered as the year that the S&P 500 got crushed by many actively managed products. In fact, some of the biggest mutual funds in the U.S. have been beating the S&P 500 by holding fairly sizeable cash reserves. One of the reasons that the stock market has had some big one-day rallies recently is that these mutual funds are forced to get back into the stock market very quickly, and aggressively buy stocks, otherwise they risk falling behind the S&P 500.

The fact of the matter is that the capitalization weighting of the S&P 500 has been a disaster in recent years. Although capitalization weighting helped the S&P 500's performance when only 7 stocks (e.g., Cisco Systems, Intel, Microsoft, Oracle, etc.) out of 500 accounted for more than 50% of the index's return back in 1999; capitalization weighting has been a disaster in recent years, especially this year.

Many investors do not realize that the S&P 500 would have been at a record high for much of this year had it been equally weighted instead of capitalization weighted. The fact that corporate cash flow and earnings are at record highs, while the S&P 500 is not, is indicative of how disastrous the capitalization weighting has been.

The S&P "free-float" adjustment that occurred between mid-March and mid-September, that was designed to reduce the S&P 500's weighting in its top 100 capitalization stocks, was also a disaster. This free-float adjustment effectively penalized the top 100 stocks with heavy insider ownership, because the free-float adjustment systematically sold all insider shares and hindered companies like eBay, Qualcomm, Wal-Mart and other stock market flagships.

The other big blunder associated with the S&P 500 is that it has yet to add Google, a Navellier holding, to the index. When Gillette was removed recently from the S&P 500, it is being acquired by Proctor & Gamble, many observers were shocked to learn that Gillette was being replaced by Lennar, which is a homebuilder, because virtually everyone expected that Google would be added. Google will probably finally be added to the S&P 500 as a substitute for Siebel Systems, which is being acquired by Oracle. In the interim, as Google climbs higher in the wake of its stunning quarterly sales (up 96%) and earnings (up over seven-fold), the S&P 500 continues to fall behind many big mutual funds that own Google.

The fact of the matter is that many on Wall Street have sold index funds or tracking managers who are highly correlated to the S&P 500 because they incur less liability. This is the primary reason that indexing has become so successful during the past three decades. However, as word continues to leak that the S&P 500's capitalization weighting, free-float adjustment, and failure to add Google have all served to hinder this former mighty index, more and more investors will leave the S&P 500 and head back to picking fundamentally superior investments.

I expect that an increasing number of investors will abandon indexing and tracking managers, who are essentially closet indexers, and look for better returns as we enter 2006. This bodes well for mutual funds and private accounts that have consistently outperformed the S&P 500. As a result, I expect that the stock market will increasingly revert back to selecting stocks based on fundamental factors versus just trying to mimic the S&P 500.