The S&P 500's Bubble Trouble

Did the housing bust burn investors in the world's most important stock index?

By Daniel Gross
Posted Thursday, July 10, 2008, at 6:54 PM ET

The popular Standard & Poor's 500 index is effectively a stock-picker for millions of investors. At the end of 2007, some $1.5 trillion was invested in S&P 500 funds, Exchange Traded Funds, and other vehicles that mimic the index's composition, and $4.85 trillion were invested in funds whose performance is benchmarked to the S&P 500. But as I noted in Slate nearly six years ago, the methodology S&P employs to compile and maintain the index leaves it vulnerable to bubbles.

The composition of the index is always changing, as the companies comprising it merge, get bought by private equity funds, go bankrupt, or shrink to the point of irrelevance. When the S&P Index committee evaluates potential new members, it applies certain criteria: Companies must possess a market capitalization of at least $5 billion and show four consecutive quarters of profits. The committee also uses new additions to ensure that the index remains representative of a highly dynamic economy. If the economy is becoming more dominated by information technology, as was the case in the 1990s, the committee will be more likely to replace a shoe company with a software company.