Decisions by the Thousand

Geri Hom may never become a celebrity among mutual fund managers. She runs the Schwab 1,000 Fund, an index portfolio, and thus doesn’t get to make the type of market calls and individual stock bets that create stars among her fund manager peers.

Hom spends her time making sure that investor dollars flowing into the fund are plowed into the 1,000 stocks that make up its target index, and in the right proportion. That’s no simple feat: The fund must trade speedily and at minimal cost while preserving maximum tax efficiency.

Many people equate indexing with funds that track the most popular benchmark, the Standard & Poor’s 500. But there are other ways to index, with the Schwab 1,000 one of the most popular. This portfolio holds the same big stocks that are in the S&P; 500 along with the next 500 largest companies.

Schwab believes the portfolio makes sense for investors who want a broader market stake than just the top 500 stocks--perhaps a logical strategy considering how richly priced those giants have become.

Like the S&P; 500, the Schwab 1,000 has been tough to beat in recent years: It has outperformed 68% of growth-and-income stock funds over the last five years.

Hom, a San Francisco native, cut her teeth at an investment management arm of Wells Fargo Bank during the early 1980s, when indexing was coming into vogue. She joined Charles Schwab in 1995, where she’s responsible for managing several index portfolios with a combined $4.5 billion in assets.

Hom was interviewed by Russ Wiles, a mutual funds columnist for The Times.

Times: Let’s start with the basic premise for the fund: Why should investors buy stock index funds?

Hom: I think everyone should have a core holding in an index fund. You can put your money in one and forget about it. You don’t have to monitor the performance. If the market goes up 20%, your index fund will go up about 20%. With an actively managed fund, you have to worry about performance, when to sell and so on.

Indexing is a long-term strategy. Although it has caught on because of the bull market of the last few years, I think it will continue to gain in popularity. It’s best to ride the market’s ups and downs and just stay invested, because everyone knows that stocks in the long run will outperform bonds and cash. Keeping a 25% to 50% core holding in index funds thus is a good approach.

Times: And why hold the top 1,000 U.S. stocks as opposed to the top 500?

Hom: At the inception of this fund, in April 1991, we wanted to offer a customized fund rather than an S&P; 500 copycat. With the Schwab 1,000, you also get the mid-cap sector of the market and thus broader coverage [than just the big-cap S&P; 500].

It was Chuck Schwab’s idea, actually. He decided to go for a larger group of stocks, with more diversification, covering more of the market. These 1,000 companies account for roughly 85% of the [U.S.] market, in terms of capitalization. The smallest stock in the portfolio has about $1 billion in market capitalization.

Times: Do those second 500 stocks really add much in performance?

Hom: Yes. Certainly, there are times when our returns come pretty close to those of the S&P; 500. But there also are times when our index beats the S&P; 500, and other times when it lags a bit. It depends on how the mid-cap sector is performing.

Times: Do you buy all 1,000 stocks, in their exact weightings?

Hom: Yes, and the fund certainly has the critical mass to do that. However, I have to add that when we reconstitute the portfolio once a year, we might wind up with a little more than 1,000 stocks because some companies, such as Food Lion, have more than one class of stock. We include both.

Times: What about stocks that are delisted, privatized, merged away or otherwise drop off the top-1,000 list?

Hom: Since we reconstitute only once a year, we might lose a few companies. As stocks are merged away or drop out for other reasons, we don’t immediately add new ones to replace them. Currently, the Schwab 1,000 has 991 eligible companies.

Times: You reconstitute just once a year to keep the fund’s turnover rate low, making as few adjustments as possible in order to keep trading costs down?

Hom: Right.

Times: Do you ever buy derivatives--index options or futures, for example--as an alternative to buying each of those 1,000 stocks?

Hom: No.

Times: You also oversee a number of other index funds, including small-stock and international portfolios. Does indexing also work well in these other areas?

Hom: Yes. In the small-cap area, active managers certainly can add value. There are inefficiencies in how small stocks trade, and active managers sometimes can take advantage of those inefficiencies. However, no one manager consistently will outperform.

It’s the same problem you encounter when you pick an active fund manager who specializes in large stocks. Will he outperform the market indefinitely? Probably not. Suppose 30% of active managers beat an index each year over time. You will find that it’s not the same 30% year after year.

I’m not making any industry or individual-stock bets, whereas other fund managers are. You know what you’re going to get with an index fund. We’ll buy the 1,000 stocks.

Times: Let’s talk a bit about the mechanics of running your fund. Suppose you get $1 million in cash flowing into your fund in a day. How do you apportion it among your target stocks?

Hom: With $1 million coming into a $2.5-billion portfolio, we don’t have to buy all 1,000 stocks that day. We tend to buy only what’s underweighted, and we’re typically underweighted in only a handful of stocks at any moment. [For example] if a company buys back shares or issues new shares [changing its market capitalization weighting in the index], we would need to re-balance.

So we use new cash inflows to correct each underweighting.

Times: So it’s very much computerized and quantitative?

Hom: Absolutely. We use a portfolio-management system that tells us which stocks we’re overweighted or underweighted in. The computer will say we will need to purchase $200,000 worth of shares to correct this underweighting, another $200,000 to correct this one, and so on.

Times: At what time during the day do you learn how much money is coming in from investors, and how much time do you have to put that cash to work?

Hom: We get a preliminary number around 11 a.m. [Pacific time] and act on that figure. Investors have until 1 p.m. to buy shares in the fund, but I can’t wait until 12:59 to get started. So we’ll act on that number received at 11 a.m., while keeping a little cash in reserve. That gives our brokers two hours to place trades. At noon, we’ll call again to see if the [cash-inflow] number has changed.

Our transfer agent calls us if we get a really big order late in the day, around 12:30 or 12:45. But even if I get a call after the market closes, I can still place after-market trades in the crossing networks [various markets designed for institutional investors that operate around the clock].

Times: What’s your biggest nightmare in running this fund--heavy redemptions, for example, or a sudden market plunge that makes it hard for you to get accurate prices?

Hom: Not the latter so much because these are the largest 1,000 stocks. If I face a liquidity problem, everyone else will too. That’s not really a concern. Rather, a major goal of this fund is to keep it tax-efficient. As a result, if we experienced many large redemption requests, it might be very difficult to keep it tax-efficient.

Times: So, in other words, you would rather not have to sell off a lot of stocks with embedded capital gains in order to meet shareholder redemptions. But if you did hit a prolonged period of redemptions, you would have to sell certain stocks and possibly realize some of those capital gains, creating a tax liability.

Hom: That’s exactly right. There are no guarantees in life. But certainly we would try to maintain the tax efficiency to the extent we could. We might initially select certain lots of a stock to sell--ones with the lowest capital gains or even [embedded] losses. That’s how we currently manage for tax efficiency. But after a while, if we experienced huge redemptions, we would have to sell lots with larger gains.

Times: If you were at a cocktail party and were trying to impress somebody, what would you describe as one of the more surprising aspects of index funds?

Hom: I’d cite the growth of indexing. When I first started here in March 1995, this fund had only $600 million. It never ceases to amaze me that cash comes in on a daily basis and is very consistent. In all the time I’ve been here, we’ve had net redemptions for maybe just two of those days.

Times: Can investors assume that the transaction costs on this fund are very small, in terms of commissions, bid-asked spreads and so on?

Hom: Yes. These are very liquid stocks. So we don’t face much in terms of market-impact costs [i.e., the risk that the fund itself, in buying, would push prices up significantly]. These stocks trade a lot of shares each day.

I try to have brokers [place multiple trades] to get an average price for that day [for a particular stock], so we don’t put any undue pressure on a stock.

Times: With other fund managers we interview, we always ask about favorite stocks. Is there any point in asking you the same question?

Hom: No. Although Charles Schwab stock is my favorite, of course. By the way, it’s a holding in the Schwab 1,000 fund, and it just got added to the S&P; 500.

(BEGIN TEXT OF INFOBOX / INFOGRAPHIC)

Schwab 1,000 Fund

Strategy: Seeks to replicate the performance of the Schwab 1,000 index, a proprietary index of the 1,000 largest U.S. stocks.

VITAL STATISTICS

*--*

Vanguard Avg. gen. Schwab 1,000 Index 500* stock fund Year-to-date total return +22.8% +24.9% +16.2% Five-year total ret. through 1996 +97.4% +101.7% +91.8%

*--*

Five biggest weightings in index:

1. General Electric 2. Coca-Cola 3. Exxon 4. Intel 5. Microsoft

Sales charge: none Assets: $2.5 billion

Min. investment: $1,000 Phone: (800) 526-8600

Morningstar risk-adjusted performance rating, 1-5: HHHH

*Vanguard Index 500 fund replicates performance of Standard & Poor’s 500 index

Sources: Lipper Analytical Services, Morningstar