Indexing Shines Despite Poor Year for S&P;

The majority of actively managed U.S. stock funds beat the Standard & Poor’s 500 index in 2000, something that last happened seven years ago.

But for many investors who are sold on the concept of indexing, last year was little more than what the numbers would suggest: an exception that does nothing to disprove the belief that active management can’t compete long-term with simply owning a piece of the entire market.

“Indexing is still a terrific strategy even though every decade there are one, two or three years when active managers outperform in the aggregate,” said Burton G. Malkiel, a professor at Princeton University and author of “A Random Walk Down Wall Street” (W.W. Norton & Co., 2000).

“Over the long haul, active managers still have to hide their heads in shame,” he said.

But perhaps not for the time being. Actively managed diversified U.S. funds lost an average of 1.9% in 2000, according to Morningstar Inc., versus a loss of 9.1% for the large-stock S&P; 500 and a loss of 10.9% for the Wilshire 5,000, the broadest U.S. market gauge.

About 70% of active funds beat the S&P; last year.

Just as the large growth stocks that dominate the major indexes had largely fueled the record five-year string of 20%-plus returns in the S&P; through 1999, their losses weighed down the S&P; last year.

Meanwhile, gains in small- and mid-size stocks helped drive returns at many managed funds.

To index-investing fans, the better performance of smaller stocks is an argument not for jettisoning S&P; index funds but rather for broadening the concept to include ownership of indexes of smaller shares and other market sectors.

In fact, investors now have a wide variety of index securities from which to choose, either to build a total index portfolio or to buffer a portfolio of active funds.

The basic index message is always the same: Because of their unpredictability, actively managed funds aren’t worth the headaches or cost. Better to just take whatever the market gives you--at least you can count on that when you index.

Malkiel points to the Janus Twenty growth stock fund. “That fund shows how tough it can be to pick a consistent winner,” he said. It soared 73% in 1998 and 65% in ‘99, only to plunge 32.4% last year.

In the long run, S&P; indexing has been the clear winner:

* During the 1990s, an average of only 40% of active managers each year beat the Wilshire index, and an average of only 37% beat the S&P;, according to Morningstar.

* Also in the ‘90s, active funds averaged annual returns of 17.4%, versus 18.4% for the Wilshire and 19% for the S&P; 500.

* Taking an even longer view, the average S&P; index mutual fund rose 15.2% a year from 1985 through 2000. That beat the 13.8% average annual return of diversified U.S. stock funds in the period.

The same argument could have been made for indexing 10 years ago, before the great blue-chip gains of the 1990s. Data from Lipper Inc. show that the S&P; 500 rose a total of 1,725% in the 30 years ended Dec. 31, 1990. The average actively managed fund’s return in that period: 1,643%.

Then why do the majority of stock fund investors still own actively managed funds? Human nature, for one: There’s always the chance you’ll pick a fund that consistently beats the indexes.

And indeed, there can be lengthy periods when the average stock fund beats the S&P; 500. The 1970s were a lousy decade for blue chips. From 1976 through 1983, the Nasdaq composite index beat the S&P; every year as smaller stocks did better than large stocks.

It could happen again, of course.

But Gus Sauter, who manages Vanguard Group’s indexing unit, including the flagship Vanguard 500 Index fund that tracks the S&P; 500, said although indexers may be “slightly boring singles-hitters,” active managers have several strikes against them from the start.

Sauter clearly has an ax to grind, but his arguments hold water.

For one thing, he notes, advisory fees and trading costs chip away at active funds’ returns, a problem minimized at index funds because they buy and hold. Index funds typically charge 0.2% of assets per year to run, compared with 1.4% for the average active fund.

“Active investors also face difficult timing decisions. They have to be right twice--when to move in and when to move out,” Sauter said. “Even if you’re right, you almost have to hit the inflection point perfectly.”

The tax disadvantages of active funds also became clear to many investors in 2000, when many of those funds lost ground but nonetheless distributed big taxable capital gains to shareholders.

Index funds, by contrast, are designed to be tax efficient with their low portfolio turnover.

S&P; 500 funds paved the way for indexing, but there were scores of new index funds and related index securities introduced last year alone, with more on the way.

“Initially, people saw the S&P; 500 and thought that’s all indexing was,” Sauter said. “But an index fund is really usually meant as a bet on the stock market in general, not a bet on large-cap, and people realize that now.”

Vanguard 500 Index, launched in 1976, has $89 billion in assets and now is the nation’s second-largest fund. Vanguard Total Stock Market fund, which was launched in 1992 and seeks to mimic the Wilshire 5,000, is far smaller, at about $17 billion. But Sauter expects the Total Stock Market fund to eventually become Vanguard’s largest.

Most financial advisors agree that it makes sense to invest beyond the S&P; 500, especially given the potential for small- and mid-size stocks to put together an extended rally at some point.

Though Sauter believes that a sound index portfolio can be set up with simply a total stock market fund, a broad bond index fund and a foreign stock index fund--in whatever percentages suit an investor’s temperament--there are myriad ways to play the indexing game, including via small-cap, mid-cap and sector funds as well as some newfangled options.

Exchange-traded funds, or ETFs, which track indexes or sectors but trade like stocks, have surged in popularity since 1999. They include “spiders,” a.k.a. S&P; 500 depositary receipts, or SPDRs; “diamonds,” which track the Dow Jones industrials; and “Qubes,” or “the Qs,” which trade under the ticker symbol QQQ and track the Nasdaq 100, an index made up of that market’s biggest nonfinancial companies--meaning mostly tech.

Last year, Barclays Global Investors rolled out 41 new “iShare” ETFs, bringing its lineup to 58, including numerous foreign ETFs.

Two firms--Allied Asset Advisors and Zad Asset Management, have launched funds tracking the Dow Jones U.S. Islamic index, designed for Muslims who want to invest according to the Koran’s laws.

Even Vanguard has gotten fancier: In June it launched Vanguard Calvert Social Index, a low-fee alternative to actively run “socially conscious” funds (which typically avoid industries such as tobacco and companies considered abusive to animals or employees).

Max Isaacman, author of “How to Be an Index Investor” (McGraw-Hill, 2000), said he likes the trading flexibility that ETFs have brought to indexing, but he advises investors to be picky when choosing among index products.

For example, although some see the Qubes as a proxy for the tech sector, Isaacman notes that the Nasdaq 100 is really a growth index with only a 70% tech weighting.

“A cleaner, purer way to play tech is the [ticker symbol] XLK--the technology SPDR,” he said.

Isaacman, like many other advisors, also thinks smaller stocks make good sense now as an index bet. He currently prefers the MDY, or mid-cap-stock SPDR.

With mid-size stocks, “you’re buying faster projected earnings growth at a more reasonable valuation” than blue chips, he said.

*

Josh Friedman can be reached at josh.friedman@latimes.com.

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Index vs. Active

The average actively managed stock fund beat the average Standard & Poor’s 500 index fund last year, giving the average active fund the edge for the three-year period. But longer term, the index fund is well ahead.

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Indexing Strategies: Beyond the S&P;

Index investing is often considered synonymous with the large-stock Standard & Poor’s 500, but there are many ways to create an indexed portfolio today - and many financial advisors in fact recommend using a number of index securities to build one that provides index representation across many market sectors. Here’s a look at some popular index investments, and where to go for information on many of the securities:

Vanguard Index Funds: A Sampling

Vanguard Group is the leading provider of index mutual funds, though it has many competitors. Here are some of the company’s key funds:

-- Vanguard 500 Index: Tracks the blue-chip Standard & Poor’s 500.

-- Vanguard Total Stock Market Index: Tracks the Wilshire 5,000 (all major U.S. stocks).

-- Vanguard Extended Market Index: Tracks the 4,500 Wilshire stocks below the 500 largest.

-- Vanguard Small Cap Index: Tracks the Russell 2,000 small-stock index.

-- Vanguard Total International Stock Index: Tracks an index of developed and emerging markets.

-- Vanguard Total Bond Market Index: Tracks an index of government and corporate bonds.

-- Vanguard Short-Term Bond Index: Tracks an index of 1- to 5-year government and corporate bonds.

Exchange-Traded Securities: A Sampling

The number of exchange-traded funds, or ETFs, has mushroomed over the last two years. These securities are designed to track a specific stock index or sector, but unlike mutual funds theytrade like regular stocks, mostly on the American Stock Exchange. Here are a few popular ETFs:

-- S&P; 500 blue-chip stock SPDR, or ‘spider’ (S&P; depositary receipt). Ticker symbol: SPY

-- S&P; 400 mid-cap stock spider. Ticker: MDY

-- S&P; technology-select spider. Ticker: XLK. Tracks 94 tech stocks in the S&P; 500.

-- Nasdaq 100 Trust. Ticker: QQQ. Tracks the 100 largest nonfinancial Nasdaq stocks.

For More Information

For more information on indexing and on the scores of ETFs available, check out these Web sites:

-- www.morningstar.com: Web site of fund tracker Morningstar Inc., featuring ETF-related articles and discussion boards. Click on “ETFs.”

-- www.indexfunds.com: Independent site, operated by San Francisco-based Index Funds Inc., offering information on index mutual funds and various related investment products. Click on “ETFs.”

-- www.amex.com: Provides information on the American Stock Exchange’s index share marketplace.

-- www.spdrindex.com: Further details on all nine Select Sector SPDRs, including basic industries, energy and technology.

-- www.holdrs.com: Details on Merrill Lynch’s lineup of 14 HOLDRs, or holding company depositary receipts, in various industry groups.

-- www.ishares.com: Information on more than 50 ETFs offered by Barclays Global Investors. Or call (800) iShares.

-- www.streettracks.com: Info on State Street Global Advisors’ lineup of ETFs, known as StreetTracks. Or call (866) S-TRACKS.

Source: Times research