Buffett joins S&P 500 as active meets passive

This essay appeared in Citywire Selector on February 2, 2010. 

For many, “the market” is the S&P 500. Nearly a trillion dollars are invested “passively” so as to emulate its performance  and exposures while 3.5 trillion are benchmarked to it.

The recent news that Warren Buffett’s Berkshire Hathaway was being added to the index reminded me of both the odd tiredness of the active passive/active divide and, more to the point, the implications for how indices are created and just what is at stake.

To my recollection, the rationale for Berkshire not being part of the index had never been the rationale for now including it: namely sufficient free float. It had always been a question of S&P not being able to categorize the kind of company it is (a holding company) and that many of its holdings (Coke, et al) were already included in the index. Berkshire, according to S&P, acts not as an operating company but an investment company. This rationale was shared by Russell (which continues to exclude Berkshire to my knowledge), S&P’s prominent competitor for index dollars.

Of course we must appreciate the irony in all of this. Warren Buffett, the greatest investor in our common history, with a tremendous track record of outperforming the S&P 500 index through a dazzling array of active techniques with no regard, in fact blatant disregard for the index, is being included (through Berkshire naturally) in the index. An estimated 6% of the company’s free float will be owned by investors in the S&P 500 index –  blindly, passively. Further, the company will be part of “the market” against which active managers compete – the makings of a peer group and index in one. The stock is up nearly 10% between the news of the 50:1 split of the B-shares and being “selected” to as a market participant.

And while the investors in the S&P are passive, its keepers are not. The constituents of the S&P 500 are chosen by a committee of eight employees of Standard and Poors. They meet monthly or more often if conditions warrant. Their goal is to compile a group of 500 stocks that they believe are a good representation of the “market” as well as the economy of the United States.

The committee is guided by a set of criteria many of which are objective and readily computable (market cap, free float, domicile, etc.) but these are only “knock out” screens. The ultimate selection of constituents is at the discretion of the committee as are the criteria that help to guide their decisions. The makings of “the” market in the end are subjectively determined.

The key difference between the S&P index committee and that of many active relative return asset managers is that the S&P staff is trying to best define the market while the investment committee is trying to beat it.  The S&P 500 is actively selected passive investing and Mr. Buffett has joined in the fun. They have incorporated an alpha source from one of the only stocks in their investable universe which they did not previously own. As the old adage goes, “if you can’t beat him, make him join you.”