Mutual Funds.

Know What You're Getting With Index Funds

Many Jump Into These Investments Without Really Knowing What Their Function Is

February 05, 1997|By Charles A. Jaffe, The Boston Globe.

There is an adage in investing that you should never buy what you don't understand.

For the better part of two decades, this is why individuals didn't buy index funds.

But in recent years, indexing has been pitched as being the solution to complex investment decisions. The result, according to Morningstar Inc., is that assets in U.S. index funds hit $93 billion in 1996, triple the total from 1994.

Mutual Fund Trim Tabs, a trade publication, estimates that 15 to 20 percent of all money entering funds in January went to index funds. And, in perhaps the ultimate sign that indexing is a viable option, fund companies that disdained index offerings are now developing their own, most notably Fidelity Investments.

That activity notwithstanding, many investors still don't know how index funds work or for whom they best work.

For proof, look no further than the front page of a recent USA Today, which touted a package of stories on index funds with this line: "Index Funds: Investors putting billions of dollars into chance to beat the stock market."

Hmmm. Since index funds always lag their index by a fraction--and since that index represents "the market"--that would mean people are trying to do the impossible.

I'd pass it off as isolated ignorance, were it not for recent letters from readers that included the following lines:

"I picked an index fund because it won't lose money."

And "If the manager of my index fund is doing so well now, why can't he turn a profit in a bear market?"

"People are just flooding into index funds without knowing what they are getting into," says Gus Sauter, a principal in the quantitative equity department at The Vanguard Group, the biggest provider of index funds. "The good news with index funds is that they do what they are supposed to do. The bad news is that some people will be surprised because they don't know what an index fund is supposed to do."

Index funds mirror the holdings of a market index, most often the Standard & Poor's 500, providing "almost-market" returns. They offer the index's performance, minus a fraction for the cost of running the fund; if the index jumps 20 percent, index fund investors take home about 19.75 percent.

The funds are "passively managed," simply mimicking the index weightings rather than having a manager try to "beat the market." Over time, most active managers lag the market, some by wide margins; index funds always come close.

Passive management keeps costs low, and the minimal portfolio turnover helps to make index funds tax-efficient.

That said, index funds serve no unique function, but are merely a different means to achieve results. They are not a one-size-fits-all fund or a strategy unto themselves, but work best as a core holding, a big part of a larger investment plan.

Before investing based on the press clippings index funds have earned in the last two years, however, understand what you are getting. Don't believe these common misconceptions:

- Index funds don't lose money. OK, index funds haven't lost money for a while, but they will. In fact, an index fund is virtually guaranteed to lose money sometime, namely whenever the market index goes down.

The Standard & Poor's 500 index is up about 70 percent over the last two years; when it someday suffers a correction, the index funds tied to it are headed for the dumper, too.

- Index funds only work if you want to own big stocks, as represented by the Standard & Poor's 500. Index funds come in all the shapes and sizes of other funds. You can find funds tied to indexes tracking small, midsize or international companies, certain investment sectors and more.

This is no one-trick pony. Pick the index you want to emulate, then find a fund that does it with the lowest "frictional costs," the expenses that eat away index returns.

- Index funds can "beat the market" over time. Costs make sure an index fund does not outperform its index. But index funds do beat most active managers over time, which means that most of the funds using traditional management techniques aren't beating the market, either.

- Active managers beat index funds in bear markets. When the market sours, an active manager is supposed to provide a cushion, where an indexer suffers loss-plus-expenses.

The difference may be small. On Black Monday in 1987, for example, the Standard & Poor's 500 was down 22 percent, while the average equity fund lost 21 percent. In other words, a lot of managers lagged the index, and most didn't beat it by much.

- You should only own an index fund during a bull market. Clearly, you only make money indexing during good times. Still, lacking an accurate crystal ball, timing the market is a loser's game; since market indexes often rise sharply after their biggest falls, jumping in and out of index funds might lock in the downturns and miss out on rebounds.

