A Way to Match the Market--and Maybe Top It

Few goals are dearer to mutual fund managers--and those who invest their money with them--than “beating the market.” Few goals are more elusive.

A lot of funds have not only failed to beat the market in recent years, they’ve fallen behind it. Some have even lost money during a bull market.

As a result, some funds no longer rely primarily on professional managers to pick their stock investments. Instead, they’ve turned to mathematical formulas that are intended to match the performance of a particular market (U.S., international, over-the-counter, etc.)--and maybe even beat it.

Now, two of the nation’s biggest mutual fund companies are introducing new, broad-based “index funds” for individual investors.

When fund managers and investors speak of “beating the market,” they usually refer to outperforming the Standard & Poor’s 500 stock price index. Sometimes, however, they may be talking about other indexes--well-known or obscure--that track different groups of U.S. stocks, bonds or foreign securities.

Reflecting the stock prices of 500 large corporations, the S&P; 500 index represents about 75% of the total value of all common stocks traded on the New York Stock Exchange--and therefore has become the most widely used benchmark for evaluating portfolio performance.

In the five years ended March 31, only 84 mutual funds outperformed the S&P; 500’s 17.5% compounded average annual total return, according to Lipper Analytical Services. This has persuaded many investors to invest at least some of their money in mutual funds that are structured to match the S&P; 500’s performance.

Managing stock portfolios to match this index has been popular with those who manage pension plan assets since passage of the Employee Retirement Income Security Act of 1974 (ERISA). Enacted in a year when the index’s total return was a negative 26.5%, ERISA included a requirement that pension fund managers diversify assets “to minimize the risk of large losses.” By linking portfolios to such a broad-based index as the S&P; 500, managers could invest in stocks while complying with the need to act prudently.

Vanguard offered shares in the first index-linked fund in August, 1976. Now known as the Vanguard Index Trust 500 Portfolio, it gave individual investors a vehicle enabling them to do about as well--or as poorly--as the broad market.

The concept was simple, even if implementation wasn’t. The fund would buy shares of all 500 companies in the same proportions that they are represented in the index, which is weighted to reflect the total market values of their shares. As investors buy or redeem shares in the fund, the fund buys or sells shares in a way that preserves the relative weights. As Standard & Poor’s adjusts the index to reflect mergers and other corporate changes, holdings are added or eliminated.

For about a decade, Vanguard had the individual investors’ S&P; 500 index fund field to itself. Beginning in 1986, a few other sponsors, such as Colonial Management Associates and Boston Co., came into the picture, but their growth was modest. (Wells Fargo, a leading manager of index-linked assets, created a fund for its customers’ IRA accounts in 1984.) Others stayed out. A Fidelity spokesman in 1987 scoffed at the idea, saying it “guaranteed long-term mediocrity.”

No more. This week, Fidelity begins selling shares in Spartan Market Index and Dreyfus is introducing its Peoples Index Fund. (They had followed SEI Financial Management Corp. in offering S&P; 500 index funds for institutions.)

“We’re responding to customer demand,” said Anne Detmer, marketing manager for Fidelity’s growth and income funds, to explain the firm’s turnabout.

Fidelity, as well as Dreyfus, also may have noted the explosive assets recently passed $2 billion. They were not discouraged by the decision of the Boston Co. (TBC) to liquidate all of its index funds. (Explained Ken Melanson, president of TBC Funds Distributor: “Our clients chose not to use them--they prefer active management.”)

All will be trying to equal the S&P; 500’s performance. Adroit portfolio management can bring them close but probably will leave a small gap for two reasons: Unlike a managed index, funds incur costs; to accommodate redemptions, they also hold small amounts of cash which, except in a down market, can drag down performance.

Their competition will be aimed at reducing the gap--and enhancing returns for shareholders--by minimizing annual operating expenses and transaction costs. Vanguard, a low-cost operator across the board, has held the 500 Portfolio’s annual expenses down to 0.22% of average net assets. To attract investors, Dreyfus and its investment adviser, Wells Fargo Nikko, are temporarily absorbing annual expenses while Fidelity is temporarily reducing fees to 0.28%.

Funds have several ways to hold down the costs of buying and selling securities, of which the easiest may be to limit excessive switching by their shareholders. George U. Sauter, the Vanguard fund’s portfolio manager, minimizes transaction costs by minimizing transactions. Unless the market is unusually volatile, he waits every day until about 3 p.m. to see whether he’ll have a net cash inflow or outflow, then buys or sells accordingly. He also uses futures contracts to remain fully invested while saving cash for redemptions.

Of course, the competition to provide investors index-linked mutual funds isn’t limited to S&P; 500 funds, as the accompanying table shows. Over the years, others have evolved--some linked to indexes developed by firms affiliated with the funds--with the objective of providing higher-than-500 returns or adding diversification to investors’ portfolios. They include:

- S&P; 500-related funds, such as those which invest equally in all 500 stocks (Dean Witter), give more weight to better performers (Vanguard Quantitative Portfolios) and concentrate in the companies represented in the S&P; 100 (Principal Preservation).

- Funds investing in companies of small and medium capitalization, which may use indexes such as the Wilshire 4,500 (Vanguard Extended Market) and Russell 2,000 (Vanguard Small Capitalization).

- Sector funds that match gold stock indexes (Benham and Rushmore), an index of natural gas distribution and transmission companies (American Gas Index), and a regional company index (Composite Northwest 50).

- International equity funds linked to the Morgan Stanley Europe, Australia, Far East Index, known as EAFE (Colonial International Equity) and to EAFE’s European and Pacific sectors (portfolios to be offered by Vanguard on May 1).

- Bond index funds matching the Salomon Bros. Broad Investment Grade Bond Index.

If a fund linked to one of these indexes attracts you, there are at least two points to remember: Because such funds are fully invested, they will be more volatile than conservative funds. Because they are volatile, you should consider them for only a portion of your assets and be prepared to stay with your choice for a few years. With such funds committed to putting all their cash into the market, Boston Co.’s Melanson points out: “There’s no way an index can protect you when the market is going down.”

GUIDE TO INDEX FUNDS

Investment Month of 12-Mo. Fund Adviser inception Total Ret. S&P; 500 Colonial U.S. Equity Index Colonial 7/86 17.05 Dreyfus Peoples Index Wells Fargo 4/90 -- Spartan Market Index Fidelity 4/90 -- Vanguard 500 Portfolio Vanguard 8/76 18.96 Other General Stock Indices Colonial Small Stock Index Colonial 7/86 0.26 Rushmore OTC Index Plus Money Mgt. 12/85 1.67 Rushmore Stock Mkt. Index+ Money Mgt. 12/85 15.49 Vanguard Extended Market Vanguard 12/87 9.25 Vanguard Small Vanguard 9/98** *** Capitalization Sector Indices American Gas Index Fund Money Mgt. 5/89 **** Benham Gold Equities Index Benham 8/88 16.69 Composite Northwest 50 Composite 11/86 29.74 Rushmore Precious Metals Money Mgt. 8/89 **** S&P; 500 Related Dean Witter Value-Added Eq. Dean Witter 11/87 10.87 Principal Preserv. S&P; 100+ Ziegler/Boston 12/85 16.04 Vanguard Quantitative Port. Franklin 12/86 19.77 International Colonial Intl. Equity Index Colonial 7/86 2.38 Vanguard Intl. European Vanguard 5/90 (est.) -- Vanguard Intl. Pacific Vanguard 5/90 (est.) -- Bond Indices Vanguard Bond Market Fund Vanguard 12/86 11.86

Maximum Fund Sales S&P; 500 Colonial U.S. Equity Index 4.75 Dreyfus Peoples Index None* Spartan Market Index None Vanguard 500 Portfolio None Other General Stock Indices Colonial Small Stock Index 4.75 Rushmore OTC Index Plus None Rushmore Stock Mkt. Index+ None Vanguard Extended Market None* Vanguard Small None Capitalization Sector Indices American Gas Index Fund None Benham Gold Equities Index None Composite Northwest 50 4.5 Rushmore Precious Metals None S&P; 500 Related Dean Witter Value-Added Eq. 5D Principal Preserv. S&P; 100+ 4.5 Vanguard Quantitative Port. None International Colonial Intl. Equity Index 4.75 Vanguard Intl. European None* Vanguard Intl. Pacific None* Bond Indices Vanguard Bond Market Fund None

* 1% transaction fee imposed for payment to fund at time of purchase (Vanguard) or redemption (Dreyfus), but no sales charge to brokers. ** Conversion of fund to new investment objective. *** Not in operation full year with new investment objective. **** Not in operation full year. D--Deferred sales charge HOT MUTUAL FUNDS PERFORMED Average total return, including dividends, in percent for periods ended Thursday, April 19 TOP 10

Fund Type Notes 12 mos. Yr.-to-date Nikko Japan Tilt Fund PC L,R * -32.36 Fund Source BIL Intl Growth IF L 17.49 0.24 Global Asset Mgmt.: Pacific Basin PC NL 20.48 -7.32 GT Global Japan PC - 15.82 -15.74 Financial Portfolio: Pacific PC NL -3.89 -12.20 Fidelity Inv: Pacific Basin PC L -8.71 -14.93 Capstone Intl: European Plus EU - 14.20 1.31 SFT:Asset Allocation FX - 0.41 0.88 Wasatch Growth Fund G NL 22.89 9.71

Fund Week Nikko Japan Tilt Fund 2.20 Fund Source BIL Intl Growth 2.03 Global Asset Mgmt.: Pacific Basin 2.00 GT Global Japan 1.84 Financial Portfolio: Pacific 1.57 Fidelity Inv: Pacific Basin 1.43 Capstone Intl: European Plus 1.40 SFT:Asset Allocation 1.33 Wasatch Growth Fund 1.26

BOTTOM 10

Fund Type Notes 12 mos. Yr.-to-date Benham Target: 2020 FI NL * -16.33 Benham Target: 2015 FI NL 8.67 -17.44 Benham Target: 2010 FI NL 9.81 -13.58 Steadman American Industry CA L -13.00 -11.82 First Investors US Govt Plus 1st FI 5.58 -10.92 -4.14 Bull & Bear Special Equities CA NL 22.98 4.98 Mackenzie Canada Fund IF -4.40 -9.37 -3.71 Benham Target: 2005 FI NL 8.91 -10.11 Equity Strategies S NL 23.25 11.45 Steadman Investment G NL -10.45% -9.77%

Fund Week Benham Target: 2020 -7.11 Benham Target: 2015 -6.07 Benham Target: 2010 -4.58 Steadman American Industry -4.43 First Investors US Govt Plus 1st Bull & Bear Special Equities -3.93 Mackenzie Canada Fund Benham Target: 2005 -3.35 Equity Strategies -3.23 Steadman Investment -3.23%

TYPE: AU = gold, B = balanced, CA = capital appreciation, CV = convertible securities, EI = equity income, EU = European regional, FI = fixed income, FS = financial securities, FX = flexible portfolio, G = growth, GI = growth and income, GL = global-international and U.S. stocks, GX = global flexible portfolio, H = health/biotechnology, I = income, IF = international, I = mixed income, NR = natural resources, OI = option income, PC = Pacific regional, RE = real estate, S = specialty/misc., SG = small company, TK = science and technology, UT = utility, WI = world income. NOTES: NL means no sales charge, LL means sales charge of 4 1/2% or less; L means sales charge of greater than 4 1/2%; R means redemption fee may apply. Source:Lipper Analytical Services