Five Myths about Indexing

In recent years, indexing has become a darling of the financial news media.
National newspapers, prominent personal finance and business magazines, and
leading cable networks have showered indexing with largely favorable
coverage. At the same time, however, several myths have been spawned about
this increasingly popular investment approach. These myths include: 

1. Indexing works only with large-cap domestic stocks. 
2. The S&P 500 Index will continue to outperform the majority of actively
   managed stock funds every year. 
3. Index funds are safer than actively managed funds. 
4. The success of indexing is a self-fulfilling prophecy. 
5. All index funds are created equal. 


Indexing works only with large-cap domestic stocks.

Many investors mistakenly equate index investing solely with the Standard &
Poor's 500 Composite Stock Price Index, a widely followed benchmark for the
U.S. stock market. The S&P 500 Index is dominated by large-capitalization,
"blue chip" stocks and represents about 70% of the stock market's total value.
It is by far the leading proxy targeted by index funds. 

The reason the media spotlight has focused on the S&P 500 Index is, in a
word, performance. The index returned 126% over the three-year period
ended December 31, 1997. By comparison, the average general equity fund is
up some 95%. The result: The return of the S&P 500 Index over the period
outpaced 93% of the returns posted by general equity funds.* 

While the extraordinary short-term performance of the S&P 500 Index has
garnered the lion's share of attention, it has overshadowed the inherent
advantages of indexing: low costs, broad diversification, and tax efficiency,
among others. What's more, the fact that the indexing approach can be
successfully applied in other securities markets—such as international stocks,
bonds, and real estate, has been largely ignored. 

In the early 1970s, when indexing came into use by large pension fund
managers, the strategy was employed almost exclusively with the broad-based
S&P 500 Index. Indexing has since moved beyond the S&P 500 Index, and
investors now have an array of index funds from which to choose. Some index
funds, for instance, attempt to match the entire U.S. stock market, as measured
by the Wilshire 5000 Equity Index or the Russell 3000 Index. Other funds seek
to parallel the performance of market subsets, such as small-cap and
medium-cap stocks. Index funds based on international stock markets are also
available. Bonds can be indexed too. The unmanaged Lehman Brothers
Aggregate Bond Index represents the entire U.S. taxable bond market,
encompassing U.S. Treasury and government agency obligations as well as
corporate bonds. 

*Source: Lipper Analytical Services, Inc. 


The S&P 500 Index will continue to outperform the majority of actively managed
stock funds every year.

The investment returns of the S&P 500 Index versus those of traditionally
managed stock funds over the past three years have simply been remarkable.
The S&P 500 Index outperformed between 75% and
90% of general equity funds annually from 1994 to 1997. 


The S&P 500 Index generally fares very well relative to active managers
because it does not incur any operating costs. However, its recent superlative
performance was enhanced by the strong returns of the large-cap stocks that
make up the index. Most actively managed funds, on the other hand, typically
invest portions of their assets in mid- and small-cap stocks, which have lagged
large-cap stocks during this time period. 

Keep in mind that the impressive relative performance of the S&P 500 Index
over the past few years is unlikely to be repeated. In each year during a
three-year stretch before 1994, for example, the index failed to outpace half of
the active fund universe. It is reasonable to assume when small- and mid-cap
stocks return to favor, the number of active funds that outpace the broad
market will increase. 

Whether active funds as a group manage to outpace the S&P 500 Index in any
given year is largely irrelevant for the long-term investor. Why? The primary
strength of the index approach is a sustainable advantage: low costs. The
estimated 0.20% annual cost of a low-cost stock index fund compares
extremely favorably with the annual cost of about 2.25% for the average equity
fund, consisting of a 1.45% expense ratio* plus estimated portfolio transaction
costs of 0.80%. In other words, the net "handicap" of 2.05% (2.25% minus 0.20%) 
makes it virtually impossible for traditionally managed mutual funds, as a group, 
to outpace low-cost index funds over time. 

Actual investment results over the past decade bear out this assertion. During
the ten years ended December 31, 1997, the S&P 500 Index outperformed
81% of all actively managed stock funds.* 

*Source: Lipper Analytical Services, Inc. 

Index funds are safer than actively managed funds.

The strong absolute and relative performance of indexing in recent years has led
some investors to believe that index funds are somehow safer than actively
managed portfolios. This belief is without merit. Simply put, index funds are not
bulletproof. 

Like their actively managed counterparts, index funds do not eliminate market
risk, the risk of fluctuation in the general level of security prices. Unlike active
funds, however, index funds hold little to no cash in their portfolios. Actively
managed funds, on the other hand, typically hold approximately 5% to 10% of
their assets in money market instruments or other short-term securities.** 

Since most index funds remain fully invested in the securities of the underlying
market benchmark, they should theoretically decline more sharply in a down
market. Such was the case in 1987. As shown in Figure 2, the S&P 500 Index
declined 32.1% from September 1987 through November 1987. By
comparison, the average general equity fund fell 28.7%. In this instance, the
cash positions held by actively managed funds cushioned the market's decline,
and these funds, as a group, outpaced the index by 3.4 percentage points. 

However, as the stock market recovered during the ensuing period, the tables
turned. From December 1987 through November 1988, the S&P 500 Index
provided an average annual total return of 25.4%, outpacing the 22.0% return
of the average general equity fund by 3.4 percentage points. So, while cash may
act as a cushion in down markets, it serves as an anchor in up markets. 

Interestingly, during the worst bear market in recent history (1973 - 1974), the
average general equity fund fared worse than the S&P 500 Index. And when
the market eventually recovered, the index outperformed the average equity
fund in the subsequent 12-month period. 

**Source: Morningstar, Inc. 


The success of indexing is a self-fulfilling prophecy.

Some market observers believe that indexing's extraordinary returns are a
self-fulfilling prophecy. Large S&P 500 Index funds, they say, are driving up the
prices of the stocks contained in the index, thus contributing to the benchmark's
stunning performance relative to active funds. The sudden surge of cash into
S&P 500 Index funds, combined with the recent performance of these funds,
would seem to prove this theory correct. 

Nonetheless, of the roughly $216 billion invested in stock mutual funds in 1997,
only an estimated $30 billion or 14% was directed to S&P 500 Index
funds. Is this sufficient to drive the entire stock market? Hardly. When
combined with the indexed assets of pension funds, indexing represents a mere
11% of the $7.6 trillion market value of stocks contained in the S&P 500
Index.* 

In addition, it should be considered that not every stock in the S&P 500 Index
is skyrocketing. 

The index's gains are being driven largely by the performance of some 50
stocks, mostly those of large, prominent companies. Index funds are certainly
buying these issues, but so too are active fund managers. And what about the
remaining 450 stocks in the index? Index funds are buying these stocks and in
the same relative proportions too. If the self-fulfilling argument were true, all
stocks in the index would be enjoying the same stellar returns. Such is not the
case. 

The success of indexing, then, is not based on its recent fame. Indeed, in the
mid-1980s, a period in which S&P 500 Index funds achieved results similar to
those of late, index funds were an unknown quantity with very modest cash
inflows. 

All index funds are created equal.

The popularity of indexing in the mid-1990s has led many investment
companies, including those that long shunned the concept—to introduce index
funds. All index funds, however, are not alike. While two index funds may target
the same benchmark, their returns may vary marginally over short time periods
and considerably over longer periods. 

The reason for varying returns is related predominantly to the funds' expense
ratios. Due to operating and administrative costs, an index fund's performance
will typically trail a given unmanaged benchmark, which does not incur any
expenses. By keeping such costs to a minimum, funds are better able to track
their respective indexes. Expense ratios for S&P 500 Index funds available to
individual investors, for example, range from as low as 0.16% to as high as
1.60%.* All things being equal, you can expect the fund with the lower expense
ratio to track the market more closely. 

However, things are rarely equal in the investing world. The execution of
security trades and brokerage costs impact a fund's ability to keep pace with
the market. Index fund managers who are better able to manage cash flows,
execute security trade orders, and minimize brokerage commissions give their
funds an even better chance of closely tracking their benchmark. 

A final caveat: Some fund sponsors are offering index funds with cut-rate
expense ratios in an effort to market the "lowest-cost index fund." Be wary of
this practice for two reasons: 

First, such funds are likely to raise their expense ratios, without warning, after 
a period of time. (Investors considering a switch to a lower-cost index fund for 
better returns would be advised to study the tax consequences of doing so.) 

Second, the performance of an index fund relative to its benchmark is affected not 
only by its expense ratio, but by other factors such as brokerage costs and fund 
management practices. 

Thus, those funds without adept management may have a higher tracking error
relative to their target benchmark. 

*Source: Lipper Analytical Services, Inc.

