Investors spend a considerable amount of time, money, and effort trying to outperform widely published stock market indices, such as the Standard & Poor's 500 Index. Unfortunately, when costs and taxes are factored into the equation, the probability of success dwindles to percentages that are less than many scratchoff lottery games.
Standard & Poor's 500 Index
The S&P 500 Index has a long history, dating back to 1923, when Standard & Poor's introduced a series of indices that included 233 companies. The S&P 500 Index itself was introduced in 1957 and was the original proxy for testing a capital asset pricing model used to predict the relationship between the risk of an asset and its expected return. The goal at the time was that the S&P 500 Index should reflect how investors actually invest in equities. Some 40 years later it continues to meet that objective; the 500 stocks in the index represent in excess of 70/ of total U.S. stock market capitalization. This is quite remarkable, considering that there are almost 8,000 U.S. stocks in Standard & Poor's database. As of April 30, 1999, the index represented nearly $11 trillion in market capitalization.
Due to the capitalization weighting of the index, it is a good benchmark for the domestic, large-capitalization style of investing. Currently, the average market capitalization of companies in the index is $21.8 billion and the median, the point at which the index could be split into two equal pools of 250 stocks, is $8.37 billion. As has been the case since the index's inception, the bulk (approximately 50/) of the capitalization is concentrated in the top 50 stocks.
Most investors do not know how the index is constructed. Companies are not chosen based solely on market capitalization, sales, or profits. Rather, Standard & Poor's goal is to choose leading companies in leading industries within the U.S. economy. In 1968, the index was added to the U.S. Department of Commerce's Index of Leading Economic Indicators. The S&P 500 Index has grown over the years to become the de facto benchmark for professional money managers.
Finally, unlike other large-cap indices, Standard & Poor's does not prematurely remove outliers (i.e., stocks that falter or become relatively small) from the S&P 500 Index, thereby reducing portfolio turnover. Minimal portfolio turnover and low dividend yield reduce the tax impact and result in extremely high tax efficiency (discussed in detail below). Furthermore, the index is relatively easy to replicate and has become quite popular, as witnessed by the massive growth in assets in the Vanguard S&P 500 Index mutual fund. This fund has grown from just over $1 billion at year-end 1988 to approxi mately $70 billion at year-end 1998. The result is that the index is truly a readily available and widely used passive alternative to active money management.
What Does an Active Manager Need to Match the S&P 500?
The first step in the analysis was to estimate the percentage of total return that is typically retained, after taxes, by the investor. Mutual funds were chosen due to the reliability of the return figures and the fact that mutual fund returns are net of fees. Using the Morningstar Principia Pro mutual fund database, the universe of mutual funds was screened to identify only large-cap products. Next, index, specialty, sector, or international funds were eliminated from the analysis. Finally, the universe was limited to mutual funds that had a minimum 10 years of tax-adjusted data. This screening resulted in 307 funds with the data necessary to estimate the average mutual fund's tax efficiency.
For each of the 307 funds, the taxadjusted return was divided by the loadadjusted return for the 3-, 5-, and 10-year periods ending April 30, 1999. The taxadjusted return shows a fund's annualized after-tax total return, excluding any capital gains effects that would result from a sale of the fund. …