Bill Ackman’s Quarterly Pershing Square Update Contains a Glaring Error

Even the “smartest” of investment managers can sometimes make mistakes – not just in the stocks they pick for their portfolio, but in their understanding of how market mechanics work.   Case in point for this post:  Pershing Square’s Bill Ackman, whose recent quarterly letter to investors demonstrated an error I chided the Associated Press for making more than 5 years ago.

Ackman, as part of a number of pages pontificating about the effects growing assets in index funds are having on the market, notes, emphasis mine:

ackman_wrong

Obviously, if you’re running a market-cap-weighted index fund, you don’t buy more shares of the companies whose stock prices are rising while selling shares of the companies whose stock prices are falling.  That’s not how cap-weighting works: it’s self re-balancing.   Changes in shares outstanding are what requires a cap-weighted index fund to rebalance – something the S&P 500 does on a quarterly basis.   As I explained it back in October of 2010:

The S&P 500 is a market cap weighted index.  That means that larger companies have a higher weight in the index.  An S&P 500 index fund will own a certain percentage of the outstanding shares of each company.  It doesn’t take a market expert to understand that when Apple’s share price rises, and its market cap rises, its value in your S&P 500 portfolio also rises!  As an S&P indexer, you don’t have to do a thing.  Changes in market cap based on share price movement are automatically self adjusting – after all, market cap  = share price x shares outstanding.
On a quarterly basis, the S&P 500 rebalances its index based on new share issuance and buybacks (in other words, changes in shares outstanding).  For example, when XOM buys back shares, S&P 500 indexers will need to sell shares of XOM.  If XOM does a secondary offering, indexers will need to buy shares of XOM.
Price movements do not create the need for S&P 500 indexers to rebalance their portfolios.
I expect errors of understanding like this from the Associated Press, but not from Bill Ackman.

A Simple Lesson in How the S&P Works

-KD

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