On this island, there is an Italian restaurant that you adore.
Once a week, you go to this place and order chicken cacciatore.
It’s made with the best ingredients and the quality is top-notch.
The increased demand for chicken cacciatore, coupled with the limited local agricultural supply of available ingredients, causes a problem for the owners of the restaurant. They substitute the heirloom tomatoes with mass produced tomatoes. A year or so goes by and they can’t get sufficient amounts of the high quality olive oil they had been using. Again, it’s not by much, but it will allow serving a much bigger audience with greater availability from suppliers. Slowly, surely, little by little, the recipe changes for the sake of profits until not a single ingredient in the dish people are eating today is the same as the dish that made the place famous.
Scalability being nearly impossible, they decide to quietly tweak the recipe, knowing a majority of customers won’t realize what happened. Now, the chicken cacciatore is the most famous meal on the island. At some point, customers begin to think, “Yeah, it’s good”, but the business doesn’t suffer immediately as it is riding on the fame of the former glory and it still remains one of the best restaurants on the island. When someone talks about a stock market “index”, what they are referring to is a list of rules.
These rules determine which individual stocks are purchased – all equity portfolios are made up of individual stocks whether you realize it or not; a mutual fund is a legal structure, not an investment – and in what proportion, substituting the composition of the rules for human judgment on a case-by-case basis.
This, ideally, leads to less emotional decisions, improving performance.
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. Now, if an investor wanted foreign-domiciled companies, he or she would have to buy index fund that focused on off-shore enterprises, the fund company, obviously, paying an additional licensing fee to Standard and Poor’s.
For the first time in generations, they unilaterally kicked all foreign companies out of the index, forcing index fund managers to sell the stocks, trigger capital gains taxes in many cases, and deny their fund owners the opportunity to profit from these international titans, many of which had been instrumental in historical S&P 500 returns. (I’m sure that didn’t influence this stupid decision.
Surely they’d be above such self-interest at investor expense, right?
I mean, this was in the midst of the corruption period when they were all but selling their imprimatur, labeling junk securities as investment grade, helping lead directly to the worst economic catastrophe since the Great Depression.
That was probably just coincidence.) Not satisfied, barely a few years later in 2005, Wall Street went at it again, changing the S&P 500 rules in a profound way that many main street investors won’t understand but that will almost assuredly enrich insiders at their expense.