The problem was not that these companies were added—it was clear that they represented an important part of the economy—but when they were added.S&P essentially took many of these speculative companies at or near their tops. When Yahoo! came in, it traded at an astronomical 228 (it's now at 13); Qualcomm traded at 159.75 when it was initiated into the club, and now it trades at 27.
S&P also contributed to the frothiness surrounding these stocks. When S&P announced an addition, it became clear that every public fund that uses the S&P 500 benchmark would have to buy that stock on the date of its inclusion. Guess what that did to the fortunate stocks?
On the day Yahoo! joined the S&P 500, it rose 67 points. And in the week between the announcement and the actual inclusion, Yahoo! rose 136 points, or 64 percent.According to a 2000 study by Salomon Smith Barney, stocks selected for inclusion outperformed the S&P 500 by 7.7 percent in the period between the announcement and the inclusion. The net effect: S&P 500 mutual funds—that is, you—effectively bought these new stocks at artificially inflated prices.
Some of the moves the committee made in 2000 turned out to be enormously bad for S&P investors, adding volatile, incredibly overpriced stocks to the index. On Jan. 28, 2000, Consolidated Natural Gas was replaced by Conexant—then an $88 stock, now a $2 stock. On March 31, auto-parts company Pep Boys was replaced by Veritas Software. On May 4, out went Reynolds Metals and CBS, in came Sapient (a $102 stock) and Siebel Systems. On July 26, JDS Uniphase subbed in for Rite Aid. And on Nov. 3, PaineWebber was swapped for Broadvision. Of the 58 stocks entering the index in 2000, 24 were Nasdaq stocks.
Joining the S&P 500 conferred a greater legitimacy on the companies and brought in a whole new class of institutional buyers who, by virtue of their mandate to follow the S&P 500, had to own the newly selected stocks. By virtue of their mandate to follow the S&P 500, they also had to hold them all the way down.
Throughout 2000 and 2001 many of the multibillion-dollar new initiates plummeted and were unceremoniously ejected from the index. Sapient, for example, was booted out after less than two years, having lost 98.4 percent of its value. Broadvision, worth $23 billion at its peak (it's now worth just $98 million), got axed after just 10 months. Conexant got disconnected last June, 30 months after its inclusion.
Investors who plowed funds into the S&P 500 thinking they were getting a conservative barometer have been sorely disappointed. Sure, the S&P 500's performance hasn't been as abysmal as the Nasdaq's—off 74 percent from its 2000 peak. But because the S&P 500 dictates the investments of millions of investors, its decline has been far more destructive.