There's a lot of trading going on inside the S&P 500

Time and time again, we hear that most actively-managed equity mutual funds fail to beat their benchmarks, like the S&P 500. In other words, investors who go out of their way to hand-pick stocks to buy and sell as they stray from the S&P 500 tend to lag more than lead.

And so, investing legends from Warren Buffett to Vanguard’s Jack Bogle recommend plopping your money into a low-cost, passively-managed index fund.

For many reasons, both amateur and professional investors are just bad at beating the benchmarks. In a new research note titled “Why Is Active Management So Difficult?,” Morgan Stanley’s Adam Parker examines this in depth.

Among other things, Parker points out that the makeup of indexes like the S&P 500 is constantly evolving.

“One of the main items that changes over time in the S&P500 is the actual constituents of the index,” Parker writes. “While there has been relatively less turnover lately, with only 3% of the companies changing since 2013, the cumulative effect of adding and subtracting companies is surprisingly substantial. Ten per cent of the companies in today’s index are different since 2011, 17% are different since 2009, and fully half the companies are different since 1999. Said another way, at least half the companies in the S&P500 today were not in the S&P500 when your average portfolio manager started running a portfolio.”

To put it another way, there is a healthy amount of trading going on in the S&P 500.

Parker charted the number of companies that have been added each year since 1965.

“On average, 22 companies, or 4.4%, are added to or removed from the index each year,” Parker wrote.

Parker noticed something of a pattern.

“[T]here is more turnover around periods of ‘market exuberance,’ such as 1995-2001 and 2005-2009,” he said. “Interestingly, in the last four years the composition of the index has been a bit more stable than the long-run average.”

So, that’s good news for investors who are long stocks.

But that doesn’t mean there still isn’t some trading going on.

“In most years 25 to 30 stocks in the S&P 500 are replaced,” said David Blitzer, S&P’s Chairman of the Index Committee. And while there are strict guidelines for what companies are added, the final decision and timing of that decision depends on what’s going through the heads of a handful of people employed by Dow Jones.

“The selection is made by the Index Committee,” Blitzer said.

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