Overview

· The S&P 500 Index has a large capitalization growth bias due to both the characteristics of recent additions and the strong performance of large cap growth stocks in the Index;

· The Index is highly concentrated in technology stocks, which represent approximately 30% of the market capitalization today, up from 12% in 1995;

· The largest 25 stocks in the Index have become expensive relative to the broader market, trading at a price-to-earnings multiple of 48 versus 20 for the remaining 475 stocks;

· The S&P 500 Index is poorly equipped to capture the performance of emerging industries like the Internet and is significantly underweighted to these stocks; and

· Taxable investors should carefully consider the potential capital gains exposure inherent in many S&P 500 Index funds.

During the five-year period ending December 31, 1999, the S&P 500 Index posted an impressive gain of 28.55% annually. Over that period the Index beat other broad market averages, such as the Russell 3000 (up 26.94% annually) and the Wilshire 5000 (up 27.06% annually), and outperformed a majority of the domestic equity mutual funds in the Morningstar^® database. This strong index performance, combined with low cost and benchmark sensitivity, has led a number of investors to conclude that buying S&P 500 Index funds is the best approach to managing their domestic equity portfolios. While this strategy provided strong results in the latter half of the 1990’s, investors should evaluate what they are buying today.

· How is the S&P 500 Index Constructed?

Stocks in the S&P 500 are chosen so that, in aggregate, they represent a broad distribution of industry groups. Unlike market benchmarks such as the Russell 1000 or the Wilshire 5000, inclusion in the Index is not automatic. Rather, the Standard & Poor’s Index Committee makes decisions about additions or deletions. Generally, new additions are drawn from under-represented segments of the market. This means that in the 1960’s steel companies were added. During the 1970’s energy company stocks were prevalent. The 1980’s saw the addition of consumer goods and healthcare companies. And in the 1990’s, financial services and technology companies dominated the new names.

When a stock is added, its weight in the index is based on the total market capitalization, including those shares that are not readily tradable. This methodology stands in contrast to the Russell weighting method, in which only free-floating shares are included. In the case of Microsoft (the largest component in both indices), the different weighting system means that MSFT comprised 4.9% of the S&P 500 but only 3.6% of the Russell 1000 as of 12/31/99.

The combination of recent additions to the index and strong performance by large capitalization growth stocks over the past two years has resulted in a style shift from large cap value in the early part of the decade to large cap growth today.

· How Did Technology Influence the Index in 1999?

1999 was a year in which technology and technology-related stocks performed extremely well while most other sectors of the market lagged. As a group, the technology sector was up 75%. Without technology the Index would have been flat. The ten best performing stocks for 1999 were all technology or technology-related companies, led by Qualcomm Inc. at +2,618%! Rounding out the top five were Sprint PCS (+343%), Nextel Communications (+336%), LSI Logic (+319%) and Nortel Networks (+304%).

The upshot of these spectacular returns is that technology now comprises more than 30% of the S&P 500 Index. As recently as 1995, only one technology company, Microsoft, could be found among the top ten stocks. Additionally, the technology sector represented just 12% of the index. Today, six of the largest companies in the index are technology-related firms – Microsoft, Cisco, Intel, Lucent, IBM and America Online.

A concentration of this magnitude in the index, while remarkable, is not unprecedented. In the late 1970’s and early 1980’s energy companies dominated the index at 27%. The top ten list included the likes of Exxon, Standard Oil of Indiana, Schlumberger, Shell Oil, Mobil Corp, Standard Oil of California and Atlantic Richfield. By 1990, the list was headed by consumer companies such as Philip Morris, Bristol Myers Squibb, Merck, Wal-Mart and Coca-Cola.

Heavy industry concentrations are a result of the committee’s bias toward including “hot” stocks and strong past performance of industry groups.

· Why Should Investors Be Concerned?

The S&P 500 Index has become increasingly concentrated. At the end of 1999, just 38 stocks accounted for over 50% of the market capitalization of the S&P 500. That number is down from 51 stocks in 1997, and 59 in 1987. Further, the top ten stocks account for over 25% of the market cap versus 17-18% on average during the 1990’s (Graph 1).

Graph 1: Number of Stocks Representing 50% of the Market Cap of the S&P 500 Index

Source: Standard & Poor’s Corporation

This concentration has tremendous implications for performance. To the degree that stocks with high weightings in the index do well, the index itself will post a strong gain. In 1999, narrow leadership in the market led to a 21% return for the index even as the median stock in the S&P was flat for the year. In an extreme representation of this phenomenon, eliminating just the top five stocks in terms of contribution (index weighting times return) would have resulted in an index return of just 12.5%. Eliminating the top thirty stocks in the same manner would have left investors with virtually a zero return (Graph 2).

Graph 2: 1999 Returns

Source: Wilshire

In today’s market, then, owning the S&P 500 Index means owning a basket of stocks that has performed well but that is increasingly driven by a narrow segment of the overall market. Investors in the Index have tied their fortunes to the winners of the past without regard to valuation level or future prospects. Based on trailing 12-month earnings, the S&P 500 Index trades at a price to earnings ratio of 30, but the largest 25 stocks in the index carry a P/E ratio of 48 while the remaining 475 names trade at a more modest P/E of 20.

Table 1: 12-Month Trailing Price-to-Earnings Ratios

Source: Wilshire

To the degree that investors become more valuation conscious, the top contributors to the S&P 500 Index may lag the market.

· Isn’t the Index a Cheap Way to Play the New Economy?

Despite its impressive 5-year track record, the S&P 500 Index lost out to both the Wilshire 5000 and the average manager as tracked by Morningstar^® in 1999. Similarly, for the five-year period from 1990 to 1994, the S&P 500 Index was a third quartile performer based on the Morningstar^® database. During periods of broader market participation and when small capitalization securities do well, the S&P 500 is ill equipped to participate.

In spite of the tremendous attention generated by the Internet, and the spectacular performance of many Internet companies, as of year-end 1999 only AOL and Yahoo! were in the S&P 500 Index. Similarly, during the early 1980’s, the S&P 500 did not capture the mini-computer boom. (Amazingly, both Apple and Intel went public on the same date in late 1982.) Also, in the early 1990’s, investors in the S&P 500 missed the sharp advance in biotechnology stocks.

Although additions to the Index tend to come from popular industries, the committee’s preference for established companies generally eliminates emerging technologies.

· Are Index Funds Tax-Efficient?

Many taxable investors have chosen S&P 500 Index Funds because they are tax-efficient. In general, these funds have very low turnover, making changes to the portfolio only when changes are made to the Index itself. Over the past several years this strategy has worked, as index funds have seen strong results and positive cash flows. For the S&P 500 Index funds tracked by Morningstar^® with at least a five-year track record, efficiency ratios average 94% for the period, meaning that investors have netted 24.7%.

Investors buying an index fund today, however, need to consider the amount of unrealized capital gains held by the fund. In essence, each new investor triggers a “buy” of the S&P 500 stocks at the current market value. But since this investor now owns a proportionate share of the entire portfolio, the potential capital gains exposure is determined by the weighted average price of all the shares owned by the fund. According to Morningstar^®, the potential capital gains exposure of S&P 500 Index funds is 40% on average. This means that an investor with $100,000 to invest is buying into a $40,000 potential capital gains distribution!

Taxable investors need to think carefully about potential capital gains exposure, especially if fund flows turn negative.

S&P 500 Index funds offer a convenient, inexpensive way to buy equities. But unlike their more actively managed counterparts, these funds do not provide a broadly diversified portfolio. With little exposure to small capitalization stocks and an underweight to value, investors who hold S&P 500 Index funds are making an implicit style bet that large cap growth stocks will continue to outperform. Still more risky, recent appreciation of a narrow market segment and index construction mechanics have created an investment vehicle that is dominated by a few large, primarily technology-related, companies. Finally, taxable investors may soon be confronted with sizeable capital gains distributions during a period of sub-par performance. Once again, investors should evaluate these investments based on the risk and reward trade-offs they offer for the future, not past results.

The information presented contains past performance. Investment return and principal value may fluctuate so that an investor’s shares on redemption may be worth more or less than the original cost. Mutual fund performance information assumes reinvestment of all dividends and capital gains. Performance assumes investment at the beginning of the period indicated and reflects all recommended reallocations and changes among the funds, including changes in investment managers and funds included in the portfolio. Information on allocations among funds, reallocations and portfolio changes is available upon request.

Performance information as shown is net of all mutual fund fees and expenses, but does not include any charge or fees which may or may not be imposed by an investor’s financial adviser which will reduce performance returns. For example, on an account charged 1% by a financial advisor with a stated annual return (net of mutual fund fees) of 10%, the net total return before taxes would be reduced from 10% to 9%. A ten year investment of $100,000 at 10% would grow to $259,400 and at 9%, to $236,700 before taxes.

Morningstar^® data is through the periods endings 12/31/99. Although the data are gathered from reliable sources, Morningstar^® cannot guarantee completeness and accuracy.

	1996	1999
S&P 500 Index	19	30
25 Largest Stocks	19	48
475 Remaining Stocks	17	20