Investing in Index Funds is Simple

There was a time when you could park your money in an index fund, sit back, and not worry too much about it

By CHRISTIANE BIRD

Nothing is simple anymore. Not even investing in index funds.

Time was, you could park your money in an index fund, sit back, and not worry too much about it. Only a limited number of index funds existed, making investment decisions easy, and almost all were tied to Standard & Poor’s 500-stock index.

But the world has changed — and investing in index funds is suddenly a lot more complicated. The fund tracker Morningstar Inc. currently follows 190 index funds — up from 79 in late 1995 and just 12 in late 1989. Only 94 of those 190 funds are tied to the S&P 500, which tracks 500 large-company stocks. The rest mirror everything from the broad Wilshire 5000 Index, which tracks the entire U.S. stock market, to the volatile Morgan Stanley Capital International Emerging Markets Index, which tracks the markets of developing countries.

The result is that many index-fund investors now have to approach their decisions with a lot more sophistication than they did even a short time ago.

“Investing in index funds is much trickier now,” says David Yeske, a certified financial planner at Yeske & Co., San Francisco. “The concept is much broader. You have dozens of indexes to choose from and need to take a good look around before making an investment decision.”

Hanhwe Kim, a 38-year-old computer programmer in San Francisco, began learning about index funds only last year, when he purchased shares in Vanguard Group’s 500 Index Fund. But already, he is considering branching out into exchange-traded funds, or ETFs, a relatively new class of index funds that are bought through a broker like stocks and trade throughout the day. Traditional index funds can be bought and sold only at each day’s closing price. Says Mr. Kim: “I like the fact that ETFs are really low cost and you can start with small amounts of money.”

How They Work

Index funds are designed to mimic the performance of the markets they track. Because index-fund managers don’t actively buy and sell stocks like those who manage diversified stock funds, index funds tend not to incur as many capital-gains taxes and to offer low operating costs. The expense ratio for the average index fund is 0.49%, compared with 1.43% for the average actively traded stock fund, according to Chicago-based Morningstar.

S&P 500 index funds soared during the 1990s, gaining more than 20% each year in the second half of the decade. But last year, investors got a rude awakening, as S&P 500 index funds fell an average of 9.2%, including reinvested dividends. Actively managed funds outperformed index funds for the first time since 1993, and net flows into S&P 500 index funds slowed to $9.38 billion through November from $30 billion in the year-earlier period, according to Financial Research Corp, a mutual-fund consulting company in Boston.

Such statistics have caused some to question the wisdom of investing in index funds in what appears to be a slowing economy. But many experts say that’s short-sighted. “How, in one year, did we get from, ‘Do active managers make any money?’ to ‘Is there a role for index funds?'” says Scott Cooley, a senior analyst at Morningstar.

Barbara Roper, director of investor protection at the nonprofit Consumer Federation of America, says, “For the average consumer, index funds may not be the only funds in your portfolio, but they probably should be at the heart.”

Investment companies seem to have a positive outlook as well. Last year they sought Securities and Exchange Commission approval for more than 100 new index funds, including ETFs, according to Federal Filings Inc., a news service in Washington owned by Dow Jones & Co., publisher of this newspaper.

Not all index funds performed badly in 2000, either. The average S&P 400 midcap index fund gained 15.6%, while the average S&P 600 small-cap index fund rose 11.1%. Flows into those categories also rose significantly. Midcap index funds garnered $2.32 billion through November, up from $772 million in the year-earlier period, while small-cap index funds gained $1.03 billion, up from $529 million.

When it comes to choosing an index fund in today’s diversified marketplace, investors need to ask a host of questions. How volatile is the index to which the fund is tied? (Sector indexes, for example, tend to fluctuate more than broad indexes.) What is the fund’s expense ratio? (These range from 0.1% for the Strong Dow 30 Value Fund to 2.9% for the PaineWebber S&P 500 Index Fund.) Does it carry a “load,” or sales charge? (A handful do.) How closely does the fund track its index? (Some funds are prone to “tracking errors,” meaning their performances don’t accurately mirror the indexes they track, perhaps because the funds have unusually high operating costs or aren’t truly representative of their indexes; many Wilshire 5000 index funds, for example, invest in only a sampling of the 8,000 companies in the index.) How efficient is the fund at minimizing taxes? (Small-cap index funds tend to be less tax-efficient than large-cap funds because they must sell stocks that have grown too large to remain in the index, thus realizing capital gains.)

In the Beginning

For many investors, index funds tied to the S&P 500 remain a good place to start. Though they lost an average of 9.2% last year, their return wasn’t much worse than that of the average actively managed large-cap-blend fund, their closest peer, which fell 7%, according to Morningstar. “No one basket is ever completely safe, but you can’t beat the traditional S&P 500 for diversity and low cost over the long term,” says Mr. Cooley, the Morningstar analyst.

When considering S&P 500 index funds, it helps to take a historical perspective. Vanguard introduced its 500 Index Fund, the first retail index fund, in 1976, but it took several years to catch on. The late 1970s were not a good time for S&P 500 funds because, like today, small-cap and midcap companies were outperforming large-cap companies. But the Vanguard 500 has since grown to be the industry’s second-largest mutual fund, with $89.4 billion in assets as of the end of last year. S&P 500 index funds also continue to hold the bulk of index-fund assets, with $272 billion out of the total $363 billion as of year end.

Investors who wish to invest in non-S&P 500 index funds have a large variety from which to choose. Some, such as the Vanguard Total Stock Market Fund, which follows the Wilshire 5000, mirror indexes that are broader than the S&P 500 and have been about as steady. But most non-S&P 500 funds are tied to more volatile indexes, the Wilshire midcap growth index, the S&P small-cap 600 index, the Dow Jones Utility Index and the Goldman Sachs Technology Index.

Even while acknowledging that the new index-fund categories offer investors more alternatives, as well as a way to beat the high expenses of actively managed funds, many experts suggest approaching them with caution. “When index funds get to be very specialized, I become less enthusiastic,” says John Rekenthaler, director of research at Morningstar.

Ed Rosenbaum, director of research at Lipper Inc., a mutual-fund tracker based in Denver, says, “You don’t really get out of the line of fire” of a declining S&P 500 by moving into more esoteric indexes — “you just step into another firing range.”

But Mr. Yeske, the San Francisco planner, sees the growing number of index-fund categories in a more positive light. “Investing in an S&P 500 index fund gave people a false sense of security,” he says. “But now with index funds available in all asset classes, it makes for a potentially safer investor environment” because even as stable an index as the S&P 500 can’t be expected to always perform well.

One category of specialized index funds that’s growing especially fast is socially responsible index funds, tied to indexes that screen companies on such criteria as equal-opportunity hiring practices and environmental awareness. Vanguard; TIAA-CREF, New York; and Calvert Group, Bethesda, Md., all introduced socially responsible index funds last year, bringing the total number to around 10. Socially responsible index funds tend to have higher expense ratios than do most index funds, but for some investors the price is worth it.

Putting Stock in Stock Cars

A number of quirky funds tied to yet narrower indexes have also recently joined the mutual-fund universe. Rushmore Group, based in Bethesda, offers the American Gas Index Fund, tied to utility and energy companies, while Conseco Capital Management Inc., Carmel, Ind., offers the Conseco StockCar Stocks Index Fund, which invests in companies loosely tied to the auto-racing industry. Some of the stock-car fund’s holdings, however, such as Disney and Time Warner, are the same as could be found in a more broad-based index fund.

Equally specialized are Internet index funds, of which there are about six, including the Internet 100 Fund, the Internet Index Fund, and the Guinness Flight Internet.com Index Fund. But these funds can be problematic because they tend to have large holdings in a few extremely big companies along with small holdings in many tiny ones, thereby compiling distorted portfolios in which a few large-company stocks drive performance. The Guinness Flight fund, for example, had 40% of its assets in only four companies at the end of December. “An investor would be better off buying stock in those four companies than buying the fund itself,” assuming those stocks did well, because he would avoid the fund’s expenses and the risks of owning its smaller companies, says Peter Di Teresa, a Morningstar senior analyst.

Also gaining momentum in the past few years have been leveraged and bear-index funds. A leveraged index fund seeks returns that amplify the index tracked by, for example, 1 1/2 or two times, meaning that if the index gains (or loses) 5%, the fund will be up (or down) a respective 7.5% or 10%. Leveraged funds do this by both purchasing stocks in the index tracked and speculating in options, which gives them the right to buy stocks at future dates at specific prices. Of course, the very strategies that promise greater returns when the index is rising also bring the risk of steeper losses in a falling market.

A bear index fund is designed to go up when its index goes down, meaning that if the index falls 2%, the fund will rise 2%. Bear funds do this through a variety of measures, including “put options,” contracts that allow them to sell stocks at specific prices. As with leveraged funds, bear funds’ strategies involve special risk: the likelihood of declines in rising markets. These types of products were introduced in 1993 by Rydex Global Advisors LLC, Rockville, Md., but are now also offered by ProFunds Advisors LLC, Bethesda, and Potomac Funds, Alexandria, Va., both founded by former Rydex staffers.

“We looked at the landscape and saw there was a lot more that could be done with index investing than just plain S&P 500 funds,” says Michael Sapir, chairman of ProFunds. “These kinds of funds are the future.”

Fund analysts don’t necessarily discourage investing in leveraged funds, but they do emphasize that these types of products tend to be considerably riskier than traditional index funds due to their use of futures, put options, and other more speculative investments. Mr. Cooley of Morningstar also says that he doesn’t usually recommend leveraged funds “because they’re a lot less tax-efficient” than conventional index funds. “They tend not to have a buy-and-hold strategy,” he says, but rather trade frequently, leading to more realized capital gains for investors.

More interesting to many industry experts are the new exchange-traded funds. Like traditional index funds, ETFs mimic market indexes, but are bought through a broker like stocks, are even more tax-efficient than funds and — most important for many investors — can be traded throughout the day. ETFs also usually offer lower expense ratios than do traditional index funds, but this is affected by how often an investor buys or sells shares because for each transaction, he must pay the broker a commission.

ETFs were introduced in 1995, but have only caught on with the mainstream investment community in the past two years. Assets invested in ETFs zoomed to an estimated $70 billion last year from $6.8 billion in 1997, with most of those assets invested in Cubes (for their ticker symbol QQQ), which mirror the Nasdaq 100, and Spiders (for Standard & Poor’s Depositary Receipts), which mirror the S&P 500.

Plenty of Choice

The strong investor demand has prompted a flurry of product development, especially at Barclays Global Investors, San Francisco, which introduced more than 40 ETFs last year and now offers a total of about 60. Marketed as iShares, the Barclays ETFs track everything from the Dow Jones Health Care Index to MSCI Malaysia, and the company has still others in the works. Several other companies, including Vanguard and ProFunds, have also announced plans to introduce exchange-traded share classes to some of their existing index funds.

ETFs are especially appropriate for investors who have a lump sum to invest upfront, thereby paying only a one-time broker’s commission, but not so good for those who want to invest on a monthly or bimonthly basis because additional commissions will have to be paid for each transaction, suggests Mr. Cooley of Morningstar. But Mr. Yeske doesn’t entirely agree. “I wouldn’t want to pay a broker a commission for every small transaction, but up to a point, I see no problem with multiple transactions,” he says, pointing out that a reasonable amount of transaction fees could be offset by the funds’ gains. He also notes that the superior tax efficiency of ETFs make them a good choice for many types of investors.

And Jon Duncan, a certified financial adviser with J. Duncan & Associates in Tacoma, Wash., says that one specific kind of ETF is appropriate for virtually all investors because of its usually reliable returns. Two years ago, he moved completely away from traditional index funds to recommend primarily Spiders to his clients.

Who says investing in index funds isn’t easy?

— Ms. Bird is a reporter for Dow Jones Newswires in New York. Karen Talley, a reporter for Dow Jones Newswires in New York, contributed to this article.