How 'Bout That Yahoo!?
On a day when the Nasdaq reached yet another all-time high, the most
astounding move was made by Yahoo, which leapt 24 percent, adding more than $17
billion to its market capitalization. Yahoo is joining the S&P 500 tomorrow
(making it only the second Internet company, after AOL, to do so), and in the
week since its addition to the index was announced its share price has risen
almost 150 points.
The situation, at least today, boiled down to too much demand chasing too
little supply. Index funds, which track the S&P directly, had to buy shares
of Yahoo in proportion to its market cap, since the S&P is market-cap
weighted. And since there are plenty of mutual fund managers out there who try
to mimic the S&P--while charging significantly more in fees than an index
fund--there was other institutional money chasing Yahoo as well. And as the
company's shares became more expensive, funds had to buy more of them (because
of the market-cap weighting). The result was a virtuous circle for sellers and
a truly vicious one for buyers.
Still, the picture seems a bit more complicated than this, because the
average trade in Yahoo today was just 503 shares. Needless to say, most
institutions are not buying stock in 500-share lots, so that means that a great
deal of the action today was driven by individual investors and, most likely,
day traders hoping to ride the stock's momentum and to get out before the
eventual fall. Today was, in that sense, a moment when this decade's crucial
stock-market trends--indexing, momentum investing, individual investing, and
the Internet--converged to make Yahoo investors very happy indeed.
It's almost certain that the stock will fall in days to come, but its ride
up has been so furious, and the company is such a good one, that it would be
surprising if the tumble were too precipitous. In any case, the most important
thing about Yahoo's addition to the S&P is not the effect on its stock
price. Instead, it's the way that addition drives home an often-overlooked but
nonetheless crucial fact about the S&P 500, that it is as actively managed
as any mutual fund.
This point was first made, as far as I can tell, by Bill Miller, the
brilliant fund manager of Legg Mason Value Trust, in a letter to his investors
earlier this year. Index funds, Miller pointed out, are passively managed,
which is to say that they simply duplicate the S&P 500 in order to
replicate the performance of the "market." But the S&P 500 itself is added
to and subtracted from in an attempt to make the index look as much like the
stock market, and the economy as a whole, as possible.
If this is the case, why is it so difficult for fund managers to beat index
funds based on the S&P? There seem to be two reasons. The first, and most
obvious, is that index funds have minuscule fees and very low transaction
costs. The second, though, is that the fact that the S&P is weighted by
market capitalization means that it manages money--and therefore
investments--in almost a textbook fashion. As companies grow more successful,
and more expensive, they take up a larger percentage of the index, and as they
grow less successful, and cheaper, they take up a smaller percentage. In other
words, the index effectively allows its winners to run and its losers to
dwindle.
You'll often hear fund managers say it's unfair to benchmark them against
the S&P because it does things like add Yahoo and take out Laidlaw (the
company that will be booted tomorrow). Assuming that Yahoo, even with its
recent run-up, will do better over the next five years than Laidlaw, then the
S&P will do better than it would otherwise have done. (Significantly
better, in fact, given the size of Yahoo's market capitalization.) But the
S&P's approach to investing--add dominant companies the market has already
rewarded--and to money management is easily replicable. It's a measure of how
addicted to trading fund managers have become that instead of replicating that
approach, they prefer to complain about it.
