Jim Wiandt

Front Run The S&P 500: Vanguard Investors, Hedge Your Bets!

In these topsy-turvy days of volatile markets, who knows what's up or down? The Dow could be up 250 today, and down 300 tomorrow. It's a fool's game playing market direction, and every diehard index fund investor knows it.

One thing we can count on, though, is the index effect. When a stock goes into the S&P 500, its price will rise - when one exits, look out below. With over one trillion dollars indexed to the erstwhile index, the effect, even on large-cap stocks, is not unexpected. Trading frenzies, coupled with the actual sales and purchases made by the index funds themselves, can drive prices up or down significantly in a short period of time.

And with a not insignificant turnover of a little over 10%, there are plenty of opportunities over the course of a year. There were 58 stocks in and 58 out in 2000. So far there have only been a handful in 2001. And as you'll see below, Merrill Lynch expects there to be at least 13 additions and subtractions by the end of the third quarter.

So mortgage the house, load up on options . . . fabulous riches await you.

OK, so the devil's in the details: buy at the announcement and the odds are you'll get front run yourself. Buy before the announcement and the stock you picked might not even make the cut . . . and its price might therefore actually fall after the announcement. Buy after the announcement and line up with the fund managers desperately seeking to track the slippery index.

Well, maybe mortgage your dog's house, and leave it up to Gus Sauter to outsmart the hedge funds.

While it is true that beating the rebalancing prices is as futile as beating the market, it's an interesting phenomenon. First of all, what is "index effect?" In my mind, it means either one of two things.

• The phenomenon that the above described effect has on index performance. Because stock prices move higher when they enter the index for no other reason than that they are entering the index, the index's performance is artificially augmented.

       or

• (Much more entertaining and cataclysmic) If the whole world converted to Boglism, like so many Moonies, the market would become a senseless blob, rendering Efficient Market Hypothesis dead in the water.

Now that I've convinced you, here are the contenders:

Potential lotto shots . . . these are all promising mid-caps primping in the foyer:

Source: Merrill Lynch

Could be like slugs in Mississippi mud:

Source: Merrill Lynch

And just for fun, here's who's been in and out:

Source: Standard and Poor's

Source: Standard and Poor's