Published September 17, 2002

Primer on Index Investing

Investors have a wide array of mutual funds from which to choose. Some portfolios are devoted to specific sectors, others are assembled based on investment strategies, and still others are developed according to stocks of different market capitalizations. The spectrum is broadened further by those funds designed to give investors international exposure, and others devoted to socially-conscious issues. Essentially, there are choices of mutual funds for just about everyone's tastes and preferences. Given the myriad topics, the choices can be overwhelming for new and experienced investors alike. In an age with so many choices, index funds comprise one area that stands above all the others in simplicity and focus, ultimately warranting consideration from all investors.

The general idea underlying index funds is rather straightforward: The portfolio is designed to mimic the risk and return of a given stock index, such as the Dow Jones Industrial Average, the S&P 500 Index, or the NASDAQ Composite. This is accomplished in any of several different ways. Fund companies that have the resources may invest in the shares of all the companies in the same proportion as they appear in the index. Other asset-management firms prefer to invest in just the majority of issues in the index, giving the portfolio index-like characteristics of risk and return.

But why should all investors at least consider adding an index fund to their respective portfolios? Index funds, either as a core holding or a tertiary component to a portfolio, offer many benefits over more-actively managed funds. For starters, it takes much of the guesswork out of investing. Instead of trying to cherry-pick stocks and funds for a portfolio, investors simply buy into an overall index.

In fact, Vanguard Investments Australia Ltd. explains that simplicity is one of the two significant benefits of index investing. With index funds, there is no need to analyze the strategy of various managers, attempting to find the one that will outperform the market through stock selection or market-timing.

Diversification is the other significant benefit to index investing, according to Vanguard. Picking top-performing stocks or funds is quite difficult. Furthermore, according to financial theory, a portfolio needs to be somewhat diversified to reduce the level of risk incurred. An index fund allows the investor to broadly diversify his/her portfolio across many different securities and sectors. While diversification restrains the upside potential by diluting the gains of the portfolio's best-performing stocks, it may also limit the downside by reducing the negative impact of the worst performers.

Another key reason to invest in an index fund is that such portfolios generally have low management fees. Management fees and similar expenses detract from the return realized by investors. This restrains gains during bull markets and adds to weakness in bear markets. True index funds require very little effort on the part of management. The chief responsibility of the fund manager is to make sure that the portfolio holds the same stocks in the same proportion as the index that it mirrors. As a result, management fees are minimal.

Funds that are more actively managed have higher cost structures. Fund companies may have a team of analysts working under management, looking for any indication that the markets have mispriced some security. Analysts turn over every rock and look under every bush to capitalize on inefficiencies in the marketplace. The management fees pay for all this work, but reduce the return realized by investors.

Of course, another problem with active management is that markets are largely efficient, so it is difficult for leaders of actively managed funds to outperform the market. An August 31, 2002 article in The Economist discusses this very topic. "Believers in the so-called efficient-market hypothesis have tried to demonstrate the impossibility of consistent outperformance." They say, "Additional analysis of a share will be futile," essentially because all information is already incorporated into the stock price.

The relative underperformance of actively managed funds has been the topic of many books and articles. As James O'Shaughnessy, chairman and CEO of O'Shaughnessy Capital Management, stated in his seminal book, What Works On Wall Street, "The approach of traditional, actively managed funds makes perfect sense until you review the record. The majority do not beat the S&P 500. This is true over both short and long time periods."

Continuing, he further clarifies this idea: "Indexing to the S&P 500 works because it sidesteps flawed decision-making and automates the simple strategy of buying the big stocks that make up the S&P 500. The mighty S&P 500 consistently beats 80% of traditionally managed funds by doing nothing more than making a disciplined bet on large-capitalization stocks."

The recent article in The Economist mentioned the relative poor performance of actively managed funds. "In Britain, two-thirds of active fund managers underperformed the index last year, even before the fees that they charged are subtracted."

This does not mean that it is impossible to find a managed fund that can beat the market. After all, O'Shaughnessy noted that the S&P 500 beat 80% of traditionally managed funds. This means that 20% perform at least as well, if not better than, the market. But the key here is consistency. As The Economist pointed out, "An average fund manager will beat the market some of the time. Over the long run, though, the great majority of fund managers will do no better than the market average."

Many others share these views on the relative worthlessness of managed funds. Consider an August 2002 Institutional Investor article in which Gary Gensler, a Goldman Sachs veteran and former undersecretary of the Treasury in the Clinton Administration, was quoted as saying, "Americans spend billions every year on money managers. Most of that is unnecessary." In his new book The Great Mutual Fund Trap, Gensler is reported as explaining that investors waste money on fund managers who fail to beat the market. Indeed, the editors of The Economist agree, "These people are rewarded for losing money."

In short, index funds provide investors with many benefits over more-actively managed portfolios. But, before diving right in and investing in an index fund, it is important to be aware of some of the shortcomings of index funds. For starters, there is no way out if a member of the index implodes. Imagine, if you will, you watched the rise in the NASDAQ Composite in the late-1990s. You didn't want to be bothered with the actual stock picking, so, instead, you invested in a mutual fund that mirrors the NASDAQ. Since reaching its peak in early-2000, the NASDAQ has shed approximately 70% of its value. Obviously, this was not the result of just one or two names, but if you held a NASDAQ fund, your portfolio would have taken a substantial hit because the fund manager could not sell out of the weaker-performing issues in the index, like the leader of a more-actively managed portfolio could.

Also, managers are generally required to keep cash on hand to handle redemptions. Because the fund will not be completely invested, it will typically lag the index that it mirrors. Although a drag in up markets, the cash position helps shield investors from the negative impact of down markets.

Different investors have different objectives, time horizons, and risk tolerance. As such, index portfolios are not necessarily for everyone. A majority of investors, however, will likely find that the benefits of index investing outweigh the shortcomings, and determine that index funds make attractive additions to their portfolios.

Erik Dellith
Analyst