joshuakennon.com: The S&P500's Dirty Little Secret

[Kriegsspiel]

The original S&P 500, one of the greatest inventions in the history of capitalism, sought to value a basket of individual stocks representing the biggest, most important market capitalization-weighted firms doing business in the United States.  It included foreign companies such as Unilever and Shell; empires with incredible profits, gushing massive dividends, and operating histories that spanned multiple centuries rather than mere decades.

In 2002, the people entrusted with the S&P 500 methodology decided to change the rules...

http://www.joshuakennon.com/sp-500s-dirty-little-secret/

I'd just started thinking about ways that bad things could happen to the indices most of us use (great timing Joshua), anyone have any more related knowledge to drop on me?

[scottish]

I guess some indices are better than others.

The TSX composite is worse than the S&P 500.    In 2000, almost 40% of the TSX composite (it might have still be called the TSE 300 then, hard to remember.)  was in 1 company.

It remains heavily weighted in resources and financials.

YMMV.

[retireatbirth]

I'm not too worried. That article sounded sensationalist. None of the changes mentioned seemed like a big deal. An index necessarily should evolve over time as the economic landscape changes. Furthermore, the ratings agencies are very much interested in restoring their credibility after the sub prime mess so I doubt they'd try anything foolish with the 500.

[SaintM]

I don't know if any of stuff in the article is true, but it bears mentioning one point:  an "index" is anything the creator makes of it.  Today, there is an index for just about any group of companies.  Some of these are total shit.

[Paul der Krake]

According to S&P, the reason for float adjustment is to distinguish between investment and control shareholders. They are arguing that there is a clear line between entities holding stock for control purposes, and the rest of us who are merely investing.

[Ynari]

I enjoyed the article. It's emphasizing caution in being sure you get what you think you're getting when you buy something.  Just because something says "Index fund" doesn't mean it's the allocation you want.

As hands-off as index investing is, if you want to optimize your return/risk, you still have to be somewhat aware of plan changes and events that may affect your preferences.

[jasman18]

The author is VERY credible. This is a really good information that everyone here should understand.

I actually understand one reason for the bad weighting. With SO MUCH money flowing into the S&P fund there simply are not enough shares to go around to have the smaller companies have a higher weighting on the index. This leaves you with just the larger companies that have the float to give everyone liquidity.

[RapmasterD]

I love Joshua's thinking and his posts. I've been spending a LOT of time on his site lately, and even did a bit of a SWF move by buying some Coca Cola stock for my four year old daughter. It gets even worse. I bought some Dasani carbonated lemon beverage at the market this morning.

But for me, this particular post was a "So what?" Incidentally, he pretty much concludes that most people should ignore what he has written in the post:

<<What should you do with this information?  Most of you should promptly ignore it.>>

[Indexer]

Step 1:  Get people to stop caring about the DJIA.  Its price weighted and only 30 stocks.  This was useful when someone had to do the calculations by hand.
Step 2:  Get the news to start showing the Dow total stock index next to the SP500 instead of the DJIA.
Step 3:  Get people to stop caring about the SP500.  Its only 500 companies.  This was useful when someone actually had to use a calculator and piece of paper to price it.
Step 4:  Get people to start looking at the Dow ex-US Global Total Stock.

We have computers and the internet now.  Tracking thousands of companies in real time isn't very hard.  If you give me a total stock index, and an international total stock index that gives me a lot of information with only 2 numbers which is the point of having an index.

[scottish]

I like reading his blog and alot of what he says seems to make sense.   Is there a specific reason why you say 

The author is VERY credible.

[LordSquidworth]

I like reading his blog and alot of what he says seems to make sense.   Is there a specific reason why you say 

The author is VERY credible.

http://beginnersinvest.about.com

He's in charge of the investing section at about.com and wrote the investing for dummies book.

We have computers and the internet now.  Tracking thousands of companies in real time isn't very hard.  If you give me a total stock index, and an international total stock index that gives me a lot of information with only 2 numbers which is the point of having an index.

Nobody needs to track thousands of companies. Most of them are junk for long term holding.

[forummm]

I like reading his blog and alot of what he says seems to make sense.   Is there a specific reason why you say 

The author is VERY credible.

http://beginnersinvest.about.com

He's in charge of the investing section at about.com and wrote the investing for dummies book.

Jim Cramer has written 7 books and has a TV show. I don't think he's "VERY credible".

[LordSquidworth]

I like reading his blog and alot of what he says seems to make sense.   Is there a specific reason why you say 

The author is VERY credible.

http://beginnersinvest.about.com

He's in charge of the investing section at about.com and wrote the investing for dummies book.

Jim Cramer has written 7 books and has a TV show. I don't think he's "VERY credible".

You answered it yourself, he's on tv.

He's an entertainer. Not an expert.


[MOD EDIT: Fixed quote tags.]

[forummm]

I like reading his blog and alot of what he says seems to make sense.   Is there a specific reason why you say 

The author is VERY credible.

http://beginnersinvest.about.com

He's in charge of the investing section at about.com and wrote the investing for dummies book.

Jim Cramer has written 7 books and has a TV show. I don't think he's "VERY credible".

You answered it yourself, he's on tv.

He's an entertainer. Not an expert.


[MOD EDIT: Fixed quote tags.]

Good point. No one online is an entertainer. They are all experts.

[scottish]

He does have some interesting things to say though.  I asked the question because M. Kennon appears to be getting ready to launch an investment newsletter (with paid subscriptions).

[arebelspy]

I asked the question because M. Kennon appears to be getting ready to launch an investment newsletter (with paid subscriptions).

Link?

[LordSquidworth]

I asked the question because M. Kennon appears to be getting ready to launch an investment newsletter (with paid subscriptions).

Link?

^^

Never seen that mentioned anywhere, and in part goes against his philosophy thus far.

[arebelspy]

I asked the question because M. Kennon appears to be getting ready to launch an investment newsletter (with paid subscriptions).

Link?

^^

Never seen that mentioned anywhere, and in part goes against his philosophy thus far.

Agreed.  That's why I'd love a citation.

[scottish]

Ok, I'm looking.    I hope it was actually Joshua Kennon's blog where I read this...

[scottish]

Hmmm, I think it was on his FAQ here:
http://www.joshuakennon.com/faqs/

False alarm though, it's not a newsletter, its a mutual fund of some sort:

At some point, when I launch a mutual fund, hedge fund, or take the holding company public, if you want to own what I own, you can just buy shares of whatever vehicle I choose to utilize.

[arebelspy]

I'd love if that happened, but IDK how old that FAQ is, or if that's still his plan.

[innerscorecard]

That's definitely not his declared plan at this stage. He's said what his actual plan is (or rather his lack of one) multiple times publicly on his blog, for everyone to see.

And he would never launch an investment newsletter.

[scottish]

He seems to be very popular with you guys.  What do you think about his style?  Is he a potential fund manager you would invest with instead of indexing?

[arebelspy]

He seems to be very popular with you guys.  What do you think about his style?  Is he a potential fund manager you would invest with instead of indexing?

Yes.

I love how he values companies, and I love that he thinks long term.  I love his transparency in his thinking.  I don't think I'd ever have to worry about him gambling on some options play to make up for short term losses (see Owen Li and Canarsie Capital for a recent example).  I think he'd be cool when a crash comes, and be able to evaluate the best opportunities.

I think he would do all of these things much better than I could myself, and could generate positive alpha on a long timeline.

It would come down to how much he charged though.  If the fees were too much, IDK that he could generate enough.  That would be the deciding factor for me, because of the type of investments he makes (solid, long term), they're not explosive growth.  And I'm good with that, that's what I want, but it also means there isn't enough to offset high fees.

My recommendation for the vast majority though is index funds.  As is his.

[hodedofome]

Interesting you would say that, I thought you didn't think guys could outperform the market arebelspy.

FWIW, there are plenty of examples of guys that were outstanding individual investors/traders (I'm talking triple digit+ returns over multiple years) that started a fund and didn't do well. They eventually shut the fund down and went back to investing for themselves. Hopefully he's aware of other folks' failures and how he won't suffer the same fate if he tries to start his own fund.

[arebelspy]

I thought you didn't think guys could outperform the market arebelspy.

After fees is the question, and long term.  Coins can outperform the market with no fee and over a short timeframe.  You always have to define your parameters.

[Kriegsspiel]

Coins?

[arebelspy]

Yeah, flipping them.

Like.. heads/tails.

Replace "Coins" with "Flipping a coin".

[Paul der Krake]

He seems to be very popular with you guys.  What do you think about his style?  Is he a potential fund manager you would invest with instead of indexing?

I am open to the idea. I like how his mind works, especially the pieces about dividend returns for blue chip companies over decades.

He's also written great articles about a diversity of issues such as stealth wealth, socio-economic indicators, and education. The commentary is always insightful and thought provoking.

[jmusic]

Yeah, flipping them.

Like.. heads/tails.

Replace "Coins" with "Flipping a coin".

Yeah, I was thinking like collectible coins.  You can "flip" those too.

Like.. buy low, sell high.

[LordSquidworth]

Interesting you would say that, I thought you didn't think guys could outperform the market arebelspy.

FWIW, there are plenty of examples of guys that were outstanding individual investors/traders (I'm talking triple digit+ returns over multiple years) that started a fund and didn't do well. They eventually shut the fund down and went back to investing for themselves. Hopefully he's aware of other folks' failures and how he won't suffer the same fate if he tries to start his own fund.

He'd probably have to do a holding company (what Berkshire is) or a hedge fund.

A mutual fund is too constrictive. They have to follow their charter, they can't just do what they think is right.

[workathomedad]

He wants holding company (not mutual fund) so investors can't just bail at market lows. In a holding company, if people sell at the wrong time shares just get cheaper and the manager doesn't need to sell underlining holdings at the wrong time.

[Jags4186]

I find it funny that people would be willing to jump in and let this guy invest their money because he writes some insightful articles about companies that have done great for the past 30 years.  Hindsight is always 20/20.

Don't get me wrong--I'm not bashing Joshua at all.  He obviously is a very smart guy and if you believe half of what he says has done incredibly well for himself.  But two things really pop out at me about him with regards to this conversation:

He has shown *some* of his claimed portfolio results based on one of the best 5 year runs in market history.  Complete laymen who bought Apple because they like the iPhone and iPad have done even better.

As far as I can tell he's never mentioned a loser he has chosen.  Probably the losers he has chosen he would consider "long term bets" and not losers.  Much like gamblers--they always remember the wins and never mention the losses.

I guess, personally, I would need to see Kennon make some calls before he invests, and then see how they do to have any sort of belief in what he says.

Say what you want about Jim Cramer--but he tells you exactly what is in his portfolio, what he trades, and when he is going to trade.  And he doesn't beat the index.

And finally...as they always say, past performance doesn't indicate future results....  Why all the faith in this guy?

[LordSquidworth]

Warren Buffett didn't share ideas or tell you exactly what he was doing.

Other successful value investors out there say as little as possible. Value investing is based off of taking advantage of market inefficiency. If you let everyone know what you're doing, you lose your edge if you've found a gem.

If he does anything he'll have to file paper work. Opening a hedge fund often includes a look at their personal performance over x years, a holding company would give access to the financials.

[jmusic]

Warren Buffett didn't share ideas or tell you exactly what he was doing.

Warren Buffett is a shark and a brilliant salesman.  He got rich by building a Wall Street investment company, not by value investing.  If you read those sleazy articles that talk about $40 to $10 Million with Buffett's face plastered next to it, the answer is to buy CocaCola in 1919 and wait FOR 96 YEARS!  (Hindsight bias?!?!?  Not a chance...)

He sells us this "value investing" story so that mom and pop business owners are more likely to sell their businesses to him than to his competition which are the other Wall Street private equity firms.

http://epicureandealmaker.blogspot.com/2015/03/uncle-warren-explains-it-all-to-you.html

Edited to add that I own some BRK.B shares.

[LordSquidworth]

Warren Buffett didn't share ideas or tell you exactly what he was doing.

Warren Buffett is a shark and a brilliant salesman.  He got rich by building a Wall Street investment company, not by value investing.  If you read those sleazy articles that talk about $40 to $10 Million with Buffett's face plastered next to it, the answer is to buy CocaCola in 1919 and wait FOR 96 YEARS!  (Hindsight bias?!?!?  Not a chance...)

He sells us this "value investing" story so that mom and pop business owners are more likely to sell their businesses to him than to his competition which are the other Wall Street private equity firms.

http://epicureandealmaker.blogspot.com/2015/03/uncle-warren-explains-it-all-to-you.html

Edited to add that I own some BRK.B shares.

Written by an investment banker...

[arebelspy]

I find it funny that people would be willing to jump in and let this guy invest their money because he writes some insightful articles about companies that have done great for the past 30 years.  Hindsight is always 20/20.

Don't get me wrong--I'm not bashing Joshua at all.  He obviously is a very smart guy and if you believe half of what he says has done incredibly well for himself.  But two things really pop out at me about him with regards to this conversation:

He has shown *some* of his claimed portfolio results based on one of the best 5 year runs in market history.  Complete laymen who bought Apple because they like the iPhone and iPad have done even better.

As far as I can tell he's never mentioned a loser he has chosen.  Probably the losers he has chosen he would consider "long term bets" and not losers.  Much like gamblers--they always remember the wins and never mention the losses.

I guess, personally, I would need to see Kennon make some calls before he invests, and then see how they do to have any sort of belief in what he says.

Say what you want about Jim Cramer--but he tells you exactly what is in his portfolio, what he trades, and when he is going to trade.  And he doesn't beat the index.

And finally...as they always say, past performance doesn't indicate future results....  Why all the faith in this guy?

Those are all valid points.

It's his mindset and approach I like. I think he knows how to value companies, and I'd be comfortable investing for solid long term plays due to that.

[jmusic]

Warren Buffett didn't share ideas or tell you exactly what he was doing.

Warren Buffett is a shark and a brilliant salesman.  He got rich by building a Wall Street investment company, not by value investing.  If you read those sleazy articles that talk about $40 to $10 Million with Buffett's face plastered next to it, the answer is to buy CocaCola in 1919 and wait FOR 96 YEARS!  (Hindsight bias?!?!?  Not a chance...)

He sells us this "value investing" story so that mom and pop business owners are more likely to sell their businesses to him than to his competition which are the other Wall Street private equity firms.

http://epicureandealmaker.blogspot.com/2015/03/uncle-warren-explains-it-all-to-you.html

Edited to add that I own some BRK.B shares.

Written by an investment banker...

True, but he makes that abundantly clear.  My apologies for not also doing so.

[LordSquidworth]

Warren Buffett didn't share ideas or tell you exactly what he was doing.

Warren Buffett is a shark and a brilliant salesman.  He got rich by building a Wall Street investment company, not by value investing.  If you read those sleazy articles that talk about $40 to $10 Million with Buffett's face plastered next to it, the answer is to buy CocaCola in 1919 and wait FOR 96 YEARS!  (Hindsight bias?!?!?  Not a chance...)

He sells us this "value investing" story so that mom and pop business owners are more likely to sell their businesses to him than to his competition which are the other Wall Street private equity firms.

http://epicureandealmaker.blogspot.com/2015/03/uncle-warren-explains-it-all-to-you.html

Edited to add that I own some BRK.B shares.

Written by an investment banker...

True, but he makes that abundantly clear.  My apologies for not also doing so.

I read it.

He illustrates your typical Wall Street investment banker with his writing. Not somebody I would take seriously critiquing Buffett.

While Buffett partakes in a bunch of transactions which are similar to private equity, like buying the companies out right, the two are not the same. At the same time you tried to argue that's not value investing. Value investing is buying shares in undervalued companies. There is no distinction between buying one share, or the whole company.

If you've studied the history of private equity, then you'd be familiar with how destructive it's been to American business, especially when wall streets involved. Wall street private equity is known for buying companies, loading them with debt, selling off portions, destroying pensions, then spinning them off in IPOs along with their debt. This is compared to people like Buffett, who buy companies out right and largely keep them together. He is a miser when it comes to the purse strings, but that's what makes him Warren Buffett.

The most recent example of the above that there is probably a lot of stuff out about would be the buyout of the twinkie maker that was then split up and the pension program destroyed, giving it's workers the shaft.

[innerscorecard]

He seems to be very popular with you guys.  What do you think about his style?  Is he a potential fund manager you would invest with instead of indexing?

I would not. I would want to invest my money in the way that Joshua invests his own money (enterprising, willing to take on more risk), rather than the way he invests other peoples' money (careful, avoids risk like the plague).

[arebelspy]

He seems to be very popular with you guys.  What do you think about his style?  Is he a potential fund manager you would invest with instead of indexing?

I would not. I would want to invest my money in the way that Joshua invests his own money (enterprising, willing to take on more risk), rather than the way he invests other peoples' money (careful, avoids risk like the plague).

That's a good point.  I'd want the latter, but I'd consider it among my safer investments, and be willing to take more risk elsewhere.  That is definitely something to consider.

A lot of his own money comes from his businesses.

[jmusic]

If you've studied the history of private equity, then you'd be familiar with how destructive it's been to American business, especially when wall streets involved. Wall street private equity is known for buying companies, loading them with debt, selling off portions, destroying pensions, then spinning them off in IPOs along with their debt. This is compared to people like Buffett, who buy companies out right and largely keep them together. He is a miser when it comes to the purse strings, but that's what makes him Warren Buffett.

The most recent example of the above that there is probably a lot of stuff out about would be the buyout of the twinkie maker that was then split up and the pension program destroyed, giving it's workers the shaft.

I'm not defending the investment banker, but his point was that WB's offer typically comes in LOWER than said private equity firms and the existing owners of the company choose to sell to him for less money than they could make otherwise.  I understand why owners might want to do that, like seeing your children leaving the nest, but it's a point nonetheless.

[innerscorecard]

Warren Buffett didn't share ideas or tell you exactly what he was doing.

Warren Buffett is a shark and a brilliant salesman.  He got rich by building a Wall Street investment company, not by value investing.  If you read those sleazy articles that talk about $40 to $10 Million with Buffett's face plastered next to it, the answer is to buy CocaCola in 1919 and wait FOR 96 YEARS!  (Hindsight bias?!?!?  Not a chance...)

He sells us this "value investing" story so that mom and pop business owners are more likely to sell their businesses to him than to his competition which are the other Wall Street private equity firms.

http://epicureandealmaker.blogspot.com/2015/03/uncle-warren-explains-it-all-to-you.html

Edited to add that I own some BRK.B shares.

You are critiquing the media straw man of Warren Buffett, not Warren Buffett. Warren Buffett was already rich and could have retired from classic value investing early in his career, running what was basically a special situations hedge fund. In fact he actually planned on retiring early, as I detailed in a post on my blog.

But he didnt'.

Late Warren Buffett, that is to say how he grew Berkshire to one of the world's largest companies, is extremely different from early Warren Buffett, which is how he got rich in any conventional sense of the word.

[LordSquidworth]

He seems to be very popular with you guys.  What do you think about his style?  Is he a potential fund manager you would invest with instead of indexing?

I would not. I would want to invest my money in the way that Joshua invests his own money (enterprising, willing to take on more risk), rather than the way he invests other peoples' money (careful, avoids risk like the plague).

You'd get that if he did a holding company. He wouldn't be investing your money/family members money, he'd be investing the companies money.

If you've studied the history of private equity, then you'd be familiar with how destructive it's been to American business, especially when wall streets involved. Wall street private equity is known for buying companies, loading them with debt, selling off portions, destroying pensions, then spinning them off in IPOs along with their debt. This is compared to people like Buffett, who buy companies out right and largely keep them together. He is a miser when it comes to the purse strings, but that's what makes him Warren Buffett.

The most recent example of the above that there is probably a lot of stuff out about would be the buyout of the twinkie maker that was then split up and the pension program destroyed, giving it's workers the shaft.

I'm not defending the investment banker, but his point was that WB's offer typically comes in LOWER than said private equity firms and the existing owners of the company choose to sell to him for less money than they could make otherwise.  I understand why owners might want to do that, like seeing your children leaving the nest, but it's a point nonetheless.

Well with the understanding that private equity will be real lenient with what they pay for a company as they'll bundle that debt with the company and eventually IPO it off, leaving the new shareholders with the pile of debt, of course they'll pay more.

Have to remember, private equity often is spending very, very little of their own money when they buy something.

Warren Buffett also has the reputation for keeping companies together, keeping employees on staff, and for the most part continuing the company. If someone built the company, really cares about it but still wants a way out, they'll accept less for that verses private equity which is likely to hack it up.

[peterpatch]

The author points out that to serve the increased demand for index style funds the quality of the holdings are suffering. As demand increases for index funds they have had to make trade off's. It's a great article and as someone who has a significant amount of funds in index funds I worry about the quality of the indexes and funds that track them going forward now that the method has become extremely popular. What else will have to be adulterated in order to serve a progressively larger investor base? Would it be better to just simulate the methodology by buying my own representative basket of stocks and just hold them forever, only taking time to reinvest dividends? Over long periods of time 1 or 2% of compounding means a lot, if Bogle taught us anything it was this. By systematically leaving out part of the representative market of stocks the indexes become materially different, though still similar, to what they were 10 or 20 years ago before these problems got to the current magnitude.  Ironically it looks like the success of indexing may be causing one of the very problems it originally solved.

[innerscorecard]

The author points out that to serve the increased demand for index style funds the quality of the holdings are suffering. As demand increases for index funds they have had to make trade off's. It's a great article and as someone who has a significant amount of funds in index funds I worry about the quality of the indexes and funds that track them going forward now that the method has become extremely popular. What else will have to be adulterated in order to serve a progressively larger investor base? Would it be better to just simulate the methodology by buying my own representative basket of stocks and just hold them forever, only taking time to reinvest dividends? Over long periods of time 1 or 2% of compounding means a lot, if Bogle taught us anything it was this. By systematically leaving out part of the representative market of stocks the indexes become materially different, though still similar, to what they were 10 or 20 years ago before these problems got to the current magnitude.  Ironically it looks like the success of indexing may be causing one of the very problems it originally solved.

Every investing strategy has a "carrying capacity." Once it exceeds that capacity there is some point at which it becomes an "anti-strategy" that will do badly. It was true of the Nifty Fifty, and it is true (although the carrying capacity is obviously higher) for market-cap weighted index funds as well.

The ceiling's pretty high for index funds, and we seem quite far from reaching that point, yet.

[scottish]

I found ownership data on Yahoo finance.   Here's Apple:
http://finance.yahoo.com/q/mh?s=AAPL+Major+Holders
I may be misinterpreting it, but it looks to me like around 20% of Apple's float is in index funds, mostly S&P 500 index funds.

Extrapolating ferociously, this suggests maybe 15% of the index is owned by index funds right now...