Market Watch : Index Funds Can Provide Safe Middle Ground
If you can’t beat it, match it. That’s the unofficial motto of people who invest in index mutual funds.
These funds hold the same batch of stocks or bonds that make up popular market indexes such as the Standard & Poor’s 500. The idea isn’t to outperform the market, just to equal it.
Index funds are slowly gaining a following. Today, there are about 25 index portfolios designed for individual investors, compared to 11 five years ago. Indexing is also catching on among institutional investors such as pension-plan managers, insurance companies and banks.
You can find mutual funds that focus on blue chip stocks (especially those in the S&P; 500), small stocks, foreign markets, energy stocks and bonds. There are even two funds that hold gold-mining shares, although their performance has been poor.
The index route is an easy way to invest in stock or bond funds, especially for people who don’t know how to tell whether one portfolio manager is better than the next.
You can rest assured that the fund you select will move in line with the index it tracks.
Yet critics, including the vast majority of portfolio managers who strive to find the best individual stocks and bonds they can, deride the index-fund approach as a cop-out.
“Generally, I feel it’s un-American,” says Roger Engemann, head of the Pasadena Group of mutual funds, based in Pasadena. “It’s striving to be mediocre.”
The mediocrity argument has some merit because roughly half of all fund managers will tend to beat a market index and half will lag it.
Consider the case of the largest and best-known index fund, the Vanguard Index Trust 500 Portfolio.
This product, which duplicates the Standard & Poor’s 500, appreciated 600%, an average of 13.8% annually, from 1977 through 1991, reports Lipper Analytical Services, which monitors fund performance.
Those certainly aren’t bad numbers. But a little more than half of all the other equity funds with 15-year track records did better. So did the S&P; 500 index, which beat the Vanguard portfolio by about half a percentage point annually.
The reason the Vanguard product trailed the S&P; 500 is that mutual funds, unlike straight market indexes, have operating costs that reduce their total returns.
Another key argument against index funds is that they stay fully invested at all times--there’s no way to build up cash holdings during tough investment climates.
On the other hand, even fund managers who have the option of moving into cash don’t always do so--or don’t do so in time to avoid big price declines.
As a case in point, the average equity fund fell 21% during the stock market crash of 1987, hardly better than the 22% drop sustained by the fully invested Vanguard Index Trust 500, says Gus Sauter, vice president in charge of indexing for the Vanguard Group in Valley Forge, Pa.
The nice thing about index funds is predictability. You always know that the portfolio will stay fully invested in a certain category of stocks or bonds, and you can rest assured that your investments will never wind up near the bottom of the mutual fund pack.
Also, you don’t need to worry that your portfolio manager might get replaced by someone else. With an actively managed fund, by contrast, “there’s always the risk that the manager you chose might switch jobs, retire or die,” Engemann concedes. When such personnel changes happen, fund companies don’t always notify investors.
But the main edge that index funds enjoy is one relating to costs.
The managers who oversee these funds don’t need to do any investment research or analysis when picking stocks or bonds--they merely buy the same securities that make up the index.
This saves money, as does the fact that they’re trading securities less frequently than active managers.
Lower costs are especially important on bond funds, as bond fund returns tend to cluster together much more closely than on the stock side.
“There’s no sense in fooling around with active managers and high expenses on bond funds,” says Tom Connelly, a Phoenix financial planner who recommends some index funds to clients. According to Sauter, active bond fund managers routinely under-perform the main fixed-income indexes because of the difference in cost.
Index funds, in short, are appropriate for investors content with a middle road. The funds won’t deliver the best results, but neither will they deliver the worst.
They’re designed for people who want to reap their fair share of profits--not those who strive to find the No. 1 performer.
“With index funds, you just get the market’s return,” Sauter says, “and that can be a little bit boring.”
Russ Wiles is a financial writer for the Arizona Republic, specializing in mutual funds.
Best Bets Among Index Funds
Index mutual funds try to equal the market’s investment return, not beat it. They do so by holding the same stocks or bonds that make up important market indexes such as the Standard & Poor’s 500. The following index portfolios are leaders in their respective categories. Data is for periods ending Dec. 31, 1991.
Energy Funds
Fund/Holdings 5-Yr. Return 1-Yr. Return Phone American Gas Index Fund/ Natural gas stocks NA* +3% 800-621-7874
Small-Company Funds
Fund/Holdings 5-Yr. Return 1-Yr. Return Phone Rushmore OTC Index Plus/ NASDAQ 100 stocks +66% +51% 800-621-7874 Vanguard Extended Market/ Wilshire 4,500 stocks +81% +42% 800-662-7447
International Stock Funds
Fund/Holdings 5-Yr. Return 1-Yr. Return Phone Vanguard International Index/ European Portfolio NA +12% 800-662-7447 Vanguard International Index/ Pacific Portfolio NA +11% 800-662-7447
Blue Chip Stock Funds
Fund/Holdings 5-Yr. Return 1-Yr. Return Vanguard Index Trust 500/ S&P; 500 stocks +101% +30% Colonial U.S. Equity Index Trust/ S&P; 500 stocks +88% +28% Fidelity Market Index Fund/ S&P; 500 stocks NA +30%
Fund/Holdings Phone Vanguard Index Trust 500/ S&P; 500 stocks 800-662-7447 Colonial U.S. Equity Index Trust/ S&P; 500 stocks 800-248-2828 Fidelity Market Index Fund/ S&P; 500 stocks 800-544-8888
Bond Funds
Fund/Holdings 5-Yr. Return 1-Yr. Return Phone Vanguard Bond Market Fund/ Government and corporate bonds +55% +15% 800-662-7447 Rushmore U.S. Government Long-Term Bond Portfolio/ 30-year Treasury bonds +58% +17% 800-621-7874 Portico Bond Index Fund/ Government and corporate bonds NA +17% 800-228-1024
* Not Available
Note: All of the above funds are no-loads, except for Colonial U.S. Equity Index, which charges a 5.75% sales fee.
Source for performance results: Lipper Analytical Services
