Horizon Kinetics wrote a great letter describing how the S&P 500 index weights companies, and more importantly, under weights more entrepreneurial companies. In 2005, in order to accommodate greater demand for shares from index linked investment products to the S&P 500 (ETF’s/index funds), a float adjustment was made to the S&P 500. This float adjusted ostensibly compensates for the reduced liquidity of major constituents caused by high insider ownership, i.e. companies with higher internal ownership are “less liquid” (less shares for the ETF’s to purchase versus the companies total market cap). This has the effect of reducing the weighting of companies with large insider ownership, like Oracle, Microsoft, and Google and increasing the relative weight of companies with lower insider ownership. In other words, when one now buys the S&P 500 index, or any product linked to it, one owns proportionally more shares of companies with a less entrepreneurial structure, and thus owns a lower percentage of companies that are more entrepreneurial in nature.
For additional reasons one should avoid indexes and to learn more about other value distortions, we direct our clients to The Investor’s Dilemma, which we make available on request:
Distortions of this sort allow enterprising investors to get bargains even when overall indexes may be overvalued.