By Christopher Farrell Mutual-fund money managers -- a well-compensated lot -- often claimed during the '90s that high-flying index funds would get their comeuppance when the good times ended. For one thing, turbulent markets are tailor-made for stock-pickers, not lumbering index funds. When the going gets rough, the masters of the universe can ditch tanking stocks and snap up companies with better profit prospects. Even more important, index funds by definition stay fully invested during good times and bad. But active managers can shore up their portfolio's performance with valuable cash.
That thesis got a test in 2001. As anyone with a 401(k) plan knows, the stock market had a dismal year, with the Russell 3000 small-cap index ending at -11.5%. Equity index funds didn't escape the carnage, with an average one-year return of -12.39% for 172 index funds, according to data compiled by fund-rating company Morningstar. But the comparable return for more than 1,000 actively managed mutual funds was -13.87%. So the index funds held their own against the masters of the universe.
Similarly, mid-cap stock mutual funds recorded a -5.06% return, vs. -4.05% for the mid-cap index funds (see table). But there was an interesting development at water's edge. Overseas index funds did surprisingly well against traditional benchmarks such as the Standard & Poor's 500-stock index. And chances are the case for indexing internationally will grow stronger going forward.
COST CONTROL. Like all index funds, one big advantage of international funds is their low cost. The annual fee for investing in the international indexes is 0.5%, vs. 1.8% for actively managed foreign funds. Also, index funds trade shares infrequently (only when a stock gets added or dropped from an index), and transaction costs for buying and selling stocks are much lower overseas than in the U.S. These cost savings will compound over time.
Changes in the main overseas market indexes are also attracting more attention. Morgan Stanley Capital International has changed the way it calculates indexes, which should get rid of some troublesome distortions. For instance, MSCI weightings had been calculated by multiplying a stock's price by the total shares outstanding. Now, MSCI multiplies the price by the number of shares the public can trade.
Professional investors believe this seemingly minor shift in calculations will make the indexes more grounded, since in many countries governments own large chunks of stock that are rarely, if ever, traded. Financial planner Ross Levin, president of Accredited Investors in Edina, Minn., indexes his clients' portfolios for large-cap domestic investments and bond investments -- and he's now starting to index internationally as well.
PLUGGING ALONG. Index-fund investors, whether domestic or international, have little reason to obsessively watch financial news or constantly troll chat rooms looking for hot stock tips or the next Warren Buffett. Life may not be as exciting, but you'll still do better than most investors -- and that's not bad at all.
Indeed, business revolutions often have inauspicious beginnings. Wireless pioneer William Marconi saw the radio as a means of advancing long-distance ship-to-shore communication. The Internet was first conceived as a small network promoting the sharing of supercomputers among researchers. Vanguard Group introduced the first S&P 500 equity index fund for retail investors in August, 1976. Initially, Wall Street turned a cold eye to a mutual-fund investment based on the heretical concept of simply matching, not beating, a market index.
Yet good ideas eventually win out. A majority of actively managed stock funds consistently fail to keep up with the S&P 500 index, which was especially true during the great bull market of the 1990s. Vanguard's 500 Index Fund is now the world's largest mutual fund, and index funds account for some 12% of America's equity markets.
As William Miller, a portfolio manager at Legg Mason, put it in the book Wizards of Wall Street: "The S&P 500 is a wonderful thing to put your money in. If somebody said, 'I've got a fund here with a really low cost that's tax efficient, with a 15- to 20-year record of beating almost everybody,' why wouldn't you own it." Why not indeed?
The Index-Fund Strategy Still Paid Off in 2001
Number of Funds
Number of Funds
Data: Morningstar Farrell is contributing economics editor for BusinessWeek. His Sound Money radio commentaries are broadcast over National Public Radio on Saturdays in nearly 200 markets nationwide. Follow his weekly Sound Money column, only on BusinessWeek Online