What Indexing Can, Can’t Be Counted On to Do
If you can’t beat ‘em, join ‘em. That explains why retail investors in 1998 plowed a record amount of money into passively managed index funds.
For a fifth consecutive year, low-cost index funds that track the Standard & Poor’s 500 --by just holding all of the stocks in the blue-chip index --beat at least three-quarters of all actively managed domestic stock funds.
Indeed, despite the tumultuous late-summer market slide, S&P; 500 index funds ended the year up about 28%.
By contrast, the typical actively managed U.S. stock fund --which trades in and out of stocks, building up expenses and taxes --gained just 13.7%, about the same as the typical government bond fund.
“Index investing is a sure strategy to gain investment returns that exceed those available from the average mutual fund, which is constantly in the market, actively buying and selling stocks in a futile attempt to gain extraordinary returns,” Princeton University economics professor Burton Malkiel writes in his forthcoming book, “Earn More, Sleep Better: Investing With Index Funds.”
But most of the evidence and arguments for indexing have focused only on funds that track the S&P; 500 index.
There are other index funds too.
Some, like Vanguard Small Cap Index, track the Russell 2,000 index of small-company stocks; others track the Morgan Stanley Capital International EAFE index, which measures the performance of European, Australian and Far Eastern stocks; still others track various Lehman Bros. bond indexes.
Are these index funds worth investing in too? They can be, although the arguments for tracking some indexes are not as strong as those for the S&P.;
Fundamentally, there’s nothing wrong with an all-index strategy, argues Mark Riepe, head of the Schwab Center for Investment Research, a unit of the brokerage. “An investor first of all has to think about how dedicated they are going to be in terms of reviewing and monitoring their funds,” Riepe says.
“If you aren’t interested in checking up on your actively managed funds periodically to see if the management style has changed, or to see if the fund manager is still employed there --if you’re not interested in doing any of that, or perhaps don’t feel that you have any particular insights on how to judge good funds --then the all-index approach is absolutely the way to go.”
But what if you are the kind of investor who routinely checks on his or her funds? And what if you can tell good funds from bad ones?
Then an all-index portfolio isn’t your best bet --in part because certain stock markets are better suited for indexing than others.
“Indexing plays a part in a well-diversified portfolio, but throwing everything into index funds isn’t the best way to go,” says Stephanie Kendall, senior mutual fund analyst for the fund-tracking firm CDA Wiesenberger in Rockville, Md.
Below, the cases either for or against indexing in various sectors:
Large-Cap Stocks
The Case for Indexing
The numbers speak for themselves. On a compounded basis, the S&P; has risen more than 300% in the 1990s. And thanks to low fees and low turnover in these portfolios, S&P; 500 index funds have captured almost all of those gains.
By contrast, the average equity fund has gained just 200%.
To be sure, four consecutive years of 20%-plus returns is exactly why some would argue not to index the S&P; 500 this year.
Notes Greg Schultz, principal with Asset Allocation Advisors in Walnut Creek, Calif.: “Just as the S&P; 500 has had a glorious period of outperformance, one of the immutable laws of the universe is regression to the mean. At some point, it’s going to have some periods of underperformance.”
Yet the case for indexing the S&P; is still compelling. The best U.S. companies generally get big enough to be in the S&P; 500, and some investors argue that the index outperforms the overall market because it tends to reflect the fastest-growing parts of the U.S. economy. Stocks dropped from the S&P; tend to be in declining industries.
Also, the typical S&P; 500 stock is traded on the New York Stock Exchange, so it meets the Big Board’s listing standards. It sports a market cap of $9.3 billion, which means it is big and that its shares are liquid. And it must have a sound balance sheet to satisfy the S&P; Index Committee’s desire for stability in the index and low turnover.
Indeed, because the S&P; 500 rarely replaces stocks --only 20 to 30 each year --index funds that track the S&P; rarely have to sell their holdings, which means trading costs and taxes are kept extremely low.
The typical S&P; 500 index fund’s expense ratio is 0.52%, compared with 1.43% for the typical domestic stock fund.
The S&P; won’t, to be sure, beat the majority of actively managed funds every year. But low expenses and quality stocks have allowed the index to beat 81% of all actively managed funds over the 10 years through 1997, according to the Schwab Center.
Small-Cap Stocks
The Case Against Indexing
The majority of small-cap managers have beaten the Russell 2,000 over the last decade.
There are a couple of reasons why. Many small companies, unlike large-cap ones, are covered by only a few Wall Street firms. Therefore, if there’s any pricing inefficiency to be exploited, small-cap fund managers are more likely to find those opportunities.
Also, consider what a small-cap index fund invests in. The Russell 2,000 tracks the 2,000 smallest stocks, based on market capitalization, in the U.S. equity market (excluding bulletin board and pink-sheet stocks, which are largely unregulated, and stocks trading for less than $1 a share).
Unlike companies in the S&P;, Russell 2,000 companies don’t need to be big, proven or even industry leaders to be in the index. They just need to be small. Which means they can’t be too successful.
Small companies that do well will eventually grow in market capitalization, which could get them tossed out of the index as they move into the mid-cap or even large-cap range. Thus, Russell index fund investors will miss out on the continued growth of these companies.
Then there is the matter of turnover. Indeed, in 1998 alone the Russell replaced 532 stocks, nearly 30% of the index, causing funds that track it to replace the same number of stocks.
The high turnover means more commissions and higher capital gains taxes for fund shareholders. In fact, the average small-cap index fund sports a turnover rate of 42% --eight times that of the Vanguard Index 500 fund.
“If an index fund does incremental trading, it will throw away its cost advantage,” notes Russel Kinnel, equity editor of Morningstar Mutual Funds. “And almost all the advantage of an index fund is cost.”
Foreign Stocks
The Case Against Indexing
Once again, it comes down to how the index is constructed.
The MSCI EAFE index, like the S&P;, is market-capitalization-weighted. But it, unlike the S&P;, tracks stocks in 21 countries. Hence, the larger a country’s overall stock market capitalization, the greater its representation in the index.
This isn’t necessarily bad. As companies in a given country grow, their representation in an international index fund will grow too. But there’s a danger here.
Consider 1989. Back then, just as Japan’s stock market was peaking, Japanese stocks accounted for a majority of the MSCI EAFE index. This means that foreign index funds were holding most of their assets in Japan just as the world’s second-largest economy headed into a decade-long hibernation.
By contrast, many active managers “tended to hold much less exposure in Japan,” notes the Schwab Center’s Riepe. “Some got out entirely.”
This ability to avoid the effects of crises abroad is one reason that 89% of actively managed foreign funds have beaten their benchmark indexes over the 10 years through 1997.
One exception: funds that follow one of the broad large-cap European stock indexes. These shares, like large-cap U.S. stocks, tend to be liquid, stable and efficiently priced --three essentials for outperformance in an index fund.
Bonds
The Case for Indexing
“The fixed-income arena is very index-able,” notes Morningstar’s Kinnel. That’s mainly because government and high-quality corporate bonds have risk factors that can be measured in standard ways.
Thus there is inherently less work involved in making buy or sell decisions with these kinds of bonds, and therefore less room for an active fund manager to make a difference in performance.
(In fact, bonds guaranteed by the U.S. government are so simple to evaluate that many investors prefer to assemble their own portfolios without using a mutual fund at all.)
And index funds, because of their low expenses, enjoy a cost advantage. That’s one reason that over the last decade, the average corporate index fund has delivered total annualized returns of 8.8%, slightly better than the 8.4% for actively managed corporate funds.
Of course, the best-performing actively managed bond funds are those that made successful bets on interest rate moves and/or on riskier bonds.
If you want a junk bond index fund, however, you’re probably out of luck. According to Morningstar’s database, there’s no such animal.
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Active Managers Versus the Indexes
Few large-cap stocks funds have beaten the Standard & Poor’s 500 index over the last 10 years, but most small-cap and foreign-stock funds have beaten their relevant indexes. Percentage of actively managed funds outperforming their index, 10-year averages though 1997:
Large-cap: 19%
Small-cap: 58%
Foreign: 89%
Note: For large-cap stocks, the index is the S&P; 500; for small caps, the index is the Russel 2,000; the index is the Morgan Stanley Capital international EAFE index.
Source: Schwab Center for Investment Research
Performance of Largest and 401(k)-Favorite Mutual Funds
The largest U.S. mutual funds --popular with investors and often found in company 401(k) plans --generally weathered 1998 better than the average domestic fund. Here are the largest funds, in order of fourth-quarter performance, as well as a selection of funds common in Southern California 401(k) plans. Included are returns for other periods and their categories and “star” ratings from Morningstar. Rating descriptions and category definitions can be found with the special tables beginning on C12.
Largest U.S. Funds
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Obj Cat 3-yr Total % Return Fund Cat Rtg Star 4th Q 1998 3-yr Janus LG 3 4 28.4 38.9 26.8 Fidelity Magellan LB 2 3 26.8 33.2 23.5 Fidelity Contrafund LB 3 4 23.5 31.3 25.3 American Cent-20thC Ultra Iv LG 2 3 23.0 34.6 23.6 Vanguard Index 500 Index LB 5 5 21.4 28.6 28.2 American: New Perspective WS 5 5 20.7 28.5 20.1 Fidelity Growth & Income LB 4 5 20.5 28.3 26.1 Fidelity Advisor T Grow Opp LV 4 4 20.4 23.9 23.3 Fidelity Equity-Income II LV 4 4 20.4 22.9 22.9 American: EuroPacific Growth FS 4 4 17.9 15.5 14.4 American: Invest Co of Amer LB 4 4 17.3 22.9 24.0 Putnam A Fund for Grow & Inc LV 3 3 16.7 15.2 20.3 Putnam B Fund for Grow & Inc LV 3 4 16.4 14.4 19.4 Fidelity Equity-Income LV 4 4 16.1 12.4 20.9 Vanguard Windsor II LV 5 5 14.9 16.4 24.1 American: Washington Mut Inv LV 5 4 14.0 19.4 24.1 Vanguard Windsor LV 1 3 13.5 0.8 15.8 Fidelity Puritan DH 4 4 12.6 16.5 18.0 American: Inc Fund of America DH 4 3 8.2 9.5 15.5 Vanguard Wellington DH 4 4 7.5 12.1 17.1
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Common Southern California 401(k) Funds
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Obj Cat 3-yr Total % Return Fund Cat Rtg Star 4th Q 1998 3-yr Putnam A New Opportunities MG 3 2 29.4 24.4 19.1 PBHG Growth MG 1 1 27.5 0.6 2.2 Putnam A Voyager LG 2 2 26.7 24.1 20.8 Vanguard US Growth LG 4 5 24.7 40.0 30.5 T Rowe Price New Horizons MG 2 2 24.6 6.3 10.9 Fidelity Blue Chip Growth LB 3 4 23.2 34.6 25.4 Neuberger Berman Tr Guard LV 1 2 23.2 2.4 12.4 Fidelity Growth Company LG 2 3 21.1 27.2 20.9 T Rowe Price Intl Stock FS 4 4 18.3 16.1 11.4 Fidelity Overseas FS 4 4 17.9 12.8 12.3 Fidelity Diversified Intl FS 5 5 15.3 14.4 16.0 Scudder International FS 4 4 14.8 18.6 13.6 Templeton I Foreign FS 3 3 12.0 -4.9 6.2 American: Balanced DH 4 3 8.6 11.1 15.0 Dodge & Cox Balanced DH 3 3 8.5 6.7 14.1 Vanguard Wellington DH 4 4 7.5 12.1 17.1 Pimco Instl Tot Return CI 5 4 0.3 9.8 8.2 Average domestic stock 16.6 12.1 17.7
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Source: Morningstar Inc.
