New Index Fund Is Slice of Entire Stock World

If you can’t make up your mind which stocks to buy, a new mutual fund essentially lets you own them all--the whole market.

The question is, do you really need to own the whole market, or is this a well-intentioned case of investment overkill?

The fund, from Valley Forge, Pa.-based Vanguard Group, is the Vanguard Index Trust Total Stock Market Portfolio. It’s designed to match the performance of the Wilshire 5,000, a market index compiled by Los Angeles-based investment firm Wilshire Associates since 1974.

Vanguard, one of the best-known names in the fund industry, has long championed the concept of “index” investing: Rather than try to pick the best stocks at any given moment, some of Vanguard’s biggest funds simply buy and hold the major stocks that make up a particular stock index.

The idea is to virtually guarantee shareholders that their investment will perform in line with the broad market, up or down. It’s not very exciting, but it assures that you won’t miss a big market rise by being in the wrong stocks and that you won’t lose much more than the market overall in a bear market.

When you index, you effectively settle for average--which, over time, is the best most investors can hope for anyway, index fans argue.

For years, mutual fund investors could choose from among index funds that mirror the blue-chip companies in the Standard & Poor’s 500 index and a few funds that attempt to copy small-stock indexes. But no single fund has tried to index the entire market--until now, with Vanguard’s Total Stock Market fund.

Gus Sauter, the manager of the new fund, says that if you buy the index concept, the allure of this fund is that “you get the broadest diversification possible, which therefore reduces your risk.”

But he concedes that many individuals may invest in the total-market fund simply because they’re betting it will earn a higher return than other index funds.

Will it? Maybe, maybe not. Because most of the stocks in the Wilshire 5,000 index are smaller issues, you need a healthy bull market in those stocks to beat the returns on the blue-chip S&P; 500 index funds.

From 1977 through 1981--a very strong period for small stocks--the Wilshire 5,000 index beat the S&P; 500 index each year, as the accompanying chart shows.

Since then, however, the Wilshire has outperformed the S&P; 500 only sporadically, including last year.

If 1991 was the start of a new long-term bull market in small stocks, as some analysts believe, the Wilshire could have many good years ahead of it. But there’s no way to predict that.

All that investors have to go on is history, and that favors the Wilshire only by a minuscule margin: Between 1972 and 1991, a 20-year period, the average annualized return on the Wilshire 5,000 index was 11.90%; for the S&P; 500, the return was 11.87%.

If that tiny difference still makes you hunger for Vanguard’s Total Stock Market fund, there’s another catch: Vanguard can’t say how closely the fund will track the Wilshire’s actual return, because the fund owns a sampling of the 5,000 Wilshire stocks rather than the entire list.

Sampling techniques are typical of index funds, because it’s more manageable and cost efficient to pick a representative number of stocks from an index than to buy the whole index.

Computer models have demonstrated that some stocks historically have had a major influence on their index, while many others are irrelevant.

But because no other mutual fund has tried to duplicate the mammoth Wilshire 5,000 via a sampling, Vanguard is in uncharted waters.

Sauter had to begin by sifting through a list of 5,900 stocks, which is the actual number of issues included in the index.

The name “Wilshire 5,000” was chosen in 1974, but since then many new stocks have been born, and Wilshire Associates has continued to lump them into the index.

From among those 5,900 stocks, Sauter has chosen about 1,400 for his fund, spread across the New York Stock Exchange, American Stock Exchange and NASDAQ over-the-counter market.

About half of those stocks are the nation’s biggest companies, he says.

The rest have been picked via a sampling technique that Sauter calls “optimization,” which uses a computer to locate the stocks that are closest to the Wilshire 5,000 average in price-to-earnings ratios, price-to-book-value ratios, dividend yields and a host of other variables.

Because the Wilshire 5,000 is a “living” index that’s constantly changing, Sauter’s selection process must be ongoing. Stocks must be added and subtracted regularly to the Total Stock Market portfolio to keep it in line with the Wilshire’s zigs and zags. So Sauter’s challenge doesn’t end with the initial 1,400 picks.

Michael Lipper, head of the fund research firm Lipper Analytical Services in New York, gives Vanguard credit for its fund innovations. But he notes that it’s important for Total Stock Market fund shareholders to understand that “you’re buying a mathematical abstraction,” not the real Wilshire 5,000.

Even so, a strong endorsement for the new fund is that Vanguard has done so well for investors with its other index funds. That success is a function both of the firm’s sampling techniques and its reputation for keeping management fees near rock-bottom, which lets shareholders take home greater returns:

* Vanguard’s Index Trust-500 portfolio, which seeks to replicate the S&P; 500 (household-name stocks such as Exxon, IBM and Coca-Cola), has performed brilliantly from its inception in 1976.

The accompanying chart compares how the Vanguard 500 fund, with $5.2 billion in assets, has tracked the S&P; 500 return. In most years, the Vanguard return is almost identical, save for the small fee the company takes.

Last year, for example, Vanguard 500 shareholders earned 30.2%, versus the 30.4% return they would have earned by owning all 500 S&P; stocks individually-- which of course most investors could never manage on their own.

* The Vanguard Extended Market Portfolio, which attempts to track the performance of the 4,500 stocks in the Wilshire index that aren’t in the S&P; index, also has performed well.

Created in 1987, the $440-million fund’s return has been within 1.60 points of the actual Wilshire 4,500 return each year. Last year, the fund was up 41.85% to the index’s 43.45% gain.

Given that Vanguard is already managing those two pieces of the total-market pie separately, putting them together in one fund wouldn’t seem like a big stretch for the company.

But the dynamics of mixing big and small stocks together, and sampling each correctly, presents a different challenge, though Sauter insists that it’s not necessarily a greater challenge.

He says Vanguard considered creating a total-market fund years ago but decided to offer the separate 500-index and 4,500-index funds instead to let investors choose how much to allocate between big and small stocks.

Now, he says, Vanguard management is convinced that buying the entire market is the logical approach.

Don Phillips, publisher of the Mutual Fund Values newsletter in Chicago, agrees. A single all-market index fund makes sense for investors who want to own stocks for the long haul but who aren’t sure how to pick one mutual fund from the next, he says.

In addition, a total-market fund removes the big-stock-vs.-small-stock guesswork, Phillips says. “That’s a choice a lot of investors don’t want to make,” he says.

Sauter knows that his new fund, with $119 million in assets, has yet to prove itself.

But he says, “In 10 years, we think the idea of indexing to the total market will be the dominant theme,” as opposed to the current rage of indexing just to the blue-chip S&P; 500.

The new fund’s minimum investment is $3,000. For more information, you can call Vanguard at (800) 241-9998.

Should You Own The Whole Market? The Vanguard Group of mutual funds has launched a new fund designed to replicate the performance of the entire stock market, as measured by the Wilshire index of 5,000 U.S. stocks. Here’s a look at how the Wilshire index has fared each year since 1977, compared with the Standard & Poor’s index of 500 blue-chip stocks. Also listed is the return on the Vanguard Index Trust-500, which since 1976 has attempted to match the S&P; index return.

Total investment return: Advantage: Year Vanguard ‘500’ S&P; 500 Wilshire 5,000 Wilshire 1977 -7.8% -7.2% -2.6% * 1978 +5.9% +6.5% +9.3% * 1979 +18.1% +18.5% +25.6% * 1980 +31.9% +32.5% +33.7% * 1981 -5.2% -4.9% -3.7% * 1982 +21.0% +21.5% +18.7% 1983 +21.3% +22.5% +23.5% * 1984 +6.2% +6.2% +3.1% 1985 +31.2% +31.6% +32.6% * 1986 +18.1% +18.6% +16.1% 1987 +4.7% +5.2% +2.3% 1988 +16.2% +16.5% +17.9% * 1989 +31.4% +31.6% +29.2% 1990 -3.3% -3.1% -6.2% 1991 +30.2% +30.4% +34.2% *

Source: Vanguard Group, Wilshire Associates

Should You Own The Whole Market?