S & P 500 Index Shouldn’t Be Only Yardstick for Judging Performance

Like the mythical Sisyphus, fund manager Nick Whitridge has a big rock to push--his $1.4-billion Babson Value fund--and a steep mountain to climb--the benchmark Standard & Poor’s 500 index of blue-chip stocks.

And Whitridge, like that tragic figure, has continued to try to push that rock up that hill and repeatedly failed.

For more than three years now, Babson Value, a large-cap value fund that invests in promising companies whose shares Whitridge considers cheap--has fallen short of the S&P; 500, which many investors use as a yardstick to make buy, sell and hold decisions on their domestic stock funds.

That’s not to say that Whitridge hasn’t come close. In 1996, he pushed Babson Value up 99% of the way. But he didn’t quite make it to the top. Then, in 1997, his fund generated returns of 26.6%, which, though impressive, nevertheless represented just 80% of the S&P;’s gains.

“There’s always some disappointment,” Whitridge said. “But we’re going to keep doing what we’re doing. One of these days, it’ll break our way.”

Whitridge’s resolve notwithstanding, is it time to give up on him?

No. But it may be time to give up on this mountain--especially given the way the S&P; has behaved lately.

Only 264 of the 3,057--or just slightly more than 8%--of the actively managed domestic stock funds Morningstar Inc. tracks are outperforming the S&P; year-to-date. That either means that 92% of the nation’s mutual fund managers are fools--they might as well have just held the stocks in the S&P--or; that there’s something up with the index itself. (I’m inclined to believe it’s a bit of both.)

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Clearly, the index has an inherent advantage. It rarely flips stocks, so its performance numbers aren’t hurt by the trading and administrative costs actively managed funds rack up. Also, one could argue that because the S&P; 500 represents the bluest of blue-chip stocks, it will by definition be composed of America’s biggest and best.

Then again, as James Stack, editor of the InvesTech Mutual Fund Advisor newsletter in Whitefish, Mont., points out, more than half of all U.S. equity funds did beat the index in the first three years of the 1990s bull market. And “what will investors think when they find themselves fully indexed to a bear market” in large-cap stocks? Stack asks.

Leah Modigliani, a U.S. equity strategist with Morgan Stanley Dean Witter in New York, recently dissected the S&P.; Here’s what she found: 14 of the largest 500 stocks in the index accounted for a stunning 99% of the index’s gains year-to-date through the end of September. Half of the S&P;’s returns could be explained by the movement in just five stocks. And Microsoft and Dell Computer alone accounted for a third of the index’s rise.

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Translation: Not only is the index capitalization-weighted--meaning that stocks with larger market values have a greater effect on the index’s results--but also that those big stocks have had a disproportionate impact on the index relative to their own weighting in recent months.

“With performance this concentrated, our benchmark has effectively been reduced to a few stocks,” Modigliani said. In a sense, then, comparing a fund against this index now is like asking a diversified mutual fund to deliver Dell Computer-like returns.

Take away the biggest of the blue chips, like Microsoft, Dell, Cisco Systems, Pfizer and Merck, and the S&P;’s lofty gains collapse. Take away the biggest 100 stocks in the index, and, for the first nine months of the year, the S&P; would have had a negative return, Modigliani said.

Un-weight the index--give equal weight to the performance of all 500 stocks, regardless of size--and the S&P; would be up only 5.4% year-to-date through the end of October, according to numbers calculated by S&P; Portfolio Services Group in New York.

So what’s the bottom line? Unless your fund is concentrated, which means it invests the bulk of its assets in a relatively small number of stocks, it probably hasn’t kept up with the S&P.; And unless your fund over-weights the stocks the S&P; itself weights more heavily, it’s not likely to have beat the index, either.

“In order to keep up [with the S&P;], the largest piece of every dollar has to go into Microsoft, whose shares are trading at nearly 50 times trailing 12-month earnings, Whitridge said. But as a value manager, of course, he can’t do that.

That’s why Modigliani says that “if you’re looking at the performance of managers, you might want to consider their mandate relative to the benchmark. Some managers are told not to hold certain stocks, so measuring the managers’ performance against the S&P; might not be appropriate.”

So what other yardstick should you use to make buy, sell or hold decisions on a fund? Compare a fund’s performance with that of the average for its peers--that is, funds with the same investment approach. Babson Value, for instance, is a large-cap value fund. Its performance is about on par with that of the average large-cap value fund over the last three years, and it’s outdistancing its peers over the last five- and 10-year periods.

Here are some other good funds that have consistently beaten their peers but are being hurt--and overlooked--by unfair comparisons with the S&P;:

AARP Growth & Value and Scudder Growth & Income, sister funds that seek out dividend-paying stocks; T. Rowe Price Equity-Income and Vanguard Equity-Income, two other funds that seek out undervalued and high-yielding large-cap stocks; L. Roy Papp Stock, which makes bets on technology and U.S.-based multinational stocks; and Columbia Growth, a large-cap growth fund that seeks out companies with stable earnings growth.

Have you been waiting to contribute to your tax-deferred 401(k) because of your employer’s rules? Let Times staff writer Paul J. Lim know about that--or about any ideas you have for fund or 401(k) columns. He can be reached at paul.lim@latimes.com.