Some love `em. Some hate `em. When it comes to index funds, many investors just can't think straight.
As has happened so often before, this is shaping up as a banner year for the most-popular index funds, those that buy and hold the stocks in the Standard & Poor's 500-stock index in an effort to match the index's performance. Including reinvested dividends, S&P 500 index funds are up 14 percent in 1995 through Thursday, far ahead of the 11 percent average for diversified U.S. stock funds run by real stock-pickers.The lesson? Boosters say it's yet another reason to load up on S&P 500 funds. Naysayers point out that the market was up even more, and dismiss indexing as guaranteed mediocrity.
They're both dead wrong.
KNOCKING THE NAYSAYERS: Many investors loathe index funds because they want to beat the market, and that isn't likely to happen if you buy an index fund.
For instance, consider the results of the Vanguard Index Trust-500 Portfolio, the oldest and largest of the S&P 500 mutual funds. The Valley Forge, Pa., fund climbed 287 percent during the decade ended April 30, somewhat less than the 297 percent gain for the S&P 500-stock index.
The Vanguard fund sure looks like guaranteed mediocrity - until you see how other stock funds performed. During the past 10 years, actively managed U.S. stock funds returned an average of just 239 percent, far worse than both the Vanguard fund and the S&P 500. In fact, during the 10-year stretch, Vanguard's S&P 500 fund beat 77 percent of U.S. stock funds.
The poor performance of stock-fund managers shouldn't be any great surprise. A lot of it comes down to costs. The Vanguard fund charges just 0.19 percent in annual expenses and spends precious little on trading, because the fund doesn't actively buy and sell stocks. The typical stock-fund manager, on the other hand, trades up a storm and levies 1.35 percent in annual expenses. These hefty investment costs have proved to be a millstone for most actively managed stock funds.
Of course, with a lot of hard work and a little luck, you might be able to spot some top-flight fund managers and thereby beat the market. I must confess to suffering from such delusions myself. But in my saner moments, I realize the odds are heavily stacked against me.
BASHING THE BOOSTERS: If the case for indexing is so compelling, should we just hand over our life savings to an S&P 500 index fund? Absolutely not.
I am alarmed at the way indexing has become synonymous with buying an S&P 500 fund. According to data from fund researchers Lipper Analytical Services, S&P 500 funds have garnered roughly 70 percent of the money invested in stock-index funds.
Yet the companies that make up the S&P 500 are a relatively small part of world stock-market value. The S&P 500 accounts for only 70 percent of the U.S. stock market, and U.S. shares constitute less than 40 percent of the global stock market.
What if the big winners over the next decade are foreign stocks or U.S. small-company shares? It could well happen. Foreign issues have lagged behind the S&P 500 for much of the past six years. Small-company stocks have done better of late, but they were weak performers through most of the 1980s. In the years ahead, both small stocks and foreign shares might play catch up. If that happens, sticking only with an S&P 500 fund will turn out to be a poor strategy.
Investors who are serious about indexing should make sure they index small-company shares and foreign issues, as well as the large-company stocks in the S&P 500. A well-diversified stock portfolio might have 50 percent invested in large shares, 20 percent in small-company issues and 30 percent overseas. Both Vanguard and San Francisco's Charles Schwab Corp. offer the funds needed to build a global index-fund portfolio.
But aren't the markets for small-company stocks and foreign shares less efficient, making it better to buy funds run by actual stock-pickers who can exploit the inefficiencies? There isn't a clear-cut answer. For the past decade, most actively managed small-stock funds have outpaced the Russell 2000 index of small-company shares, while the vast majority of foreign-stock funds have lagged behind Morgan Stanley's Europe, Australia and Far East index.
My favorite piece of evidence, however, is more anecdotal. In May 1994, Vanguard introduced an emerging-markets index fund, prompting snickers from the cognoscenti. What could be more silly than indexing the emerging markets, a stock-picker's paradise where the inefficiencies are so obvious?