The Stampede To Index Funds

At $400 billion strong, they put stock-pickers to shame

Why settle for average? Investment chieftains of many big pension funds are doing just that and licking their chops. They're tying bigger and bigger chunks of their equity investments to Standard & Poor's 500-stock index or some other market average. The majority of managers who try to beat the market by dissecting balance sheets, quizzing chief executives, and furiously trading stocks are coming up short. "It's sort of like par golf," says George U. Sauter, who heads index funds at the Vanguard Group. "Par is average, but how many golfers actually beat it?"

Two decades after the first index funds were launched, indexing is hotter than ever. In the 12 months ending Dec. 1, assets indexed to the U.S. stock market grew 46.9%, to $400.2 billion, according to Pensions & Investments (P&I). After accounting for market appreciation, that's about 7% real growth. Add international and bond index funds, and the total comes to $600 billion. Those numbers include the indexed investments of a growing number of individual investors as well. During 1995, index funds accounted for about 10% of the cash flows to equity mutual funds, according to Strategic Insight Inc., a mutual-fund consulting firm. The Vanguard Index Trust 500 Portfolio, the largest and oldest indexed mutual fund, almost doubled and is now the fourth-largest equity fund.

MARKET PROP. Part of the reason for index popularity is the bull market--with the S&P rising 37.6% last year and tagging on another 5.5% so far this year. Since an index fund is always fully invested in stocks, it's an ideal investment in a roaring market. But even in 1994, a choppy year in which the S&P finished up 1.3%, most investment managers failed to beat the benchmark. The more investors decide to put money in the indexes, the more those decisions reinforce the indexes' strengths and provide a significant prop to the stock market. Every new dollar plunked into an S&P index fund is invested in the same list of stocks, starting with General Electric Co. and AT&T and moving down the line.

The S&P 500-index is the most popular, but broader ones such as the Wilshire 5000 and small-stock indexes including the Russell 2000 are increasingly used for indexing. Some pension funds, such as those of Florida and Colorado, are employing "enhanced" index strategies, which tweak the index funds in small ways to scratch out some extra returns.

Indexing is going abroad as well. International index funds grew at about twice the rate of U.S. index funds last year, adjusted for market appreciation, reports P&I. In December, London's Barclays Bank PLC spent $443 million to acquire San Francisco-based Wells Fargo/Nikko Investment Advisors, the largest manager of index funds. The plan: export indexed investing, which is mainly a U.S. business, to clients around the world.

401(K) POWER. The rush to indexing is showing no sign of a letup. The huge number of dollars that pile up in the country's megafunds almost demand it. "Once a pension fund has over $1 billion in assets, it has no choice but to start indexing a significant portion of the portfolio," says Stephen L. Nesbitt, senior vice-president for Wilshire Associates Inc., a pension-fund consultant. "With really large funds, active management will just revert to the mean." In other words, they will earn just a market return--less management fees and transaction costs. Nesbitt says the very largest pension funds--those with more than $5 billion in assets--will likely have at least half their assets in index funds. At the $17 billion Colorado pension fund, it's two-thirds.

The proliferation of defined-contribution pension plans, such as the 401(k), is also fueling growth of indexing. In fact, much of the mutual-fund money that is getting indexed came through these plans. Now, about 46% of 401(k) plans offer equity index funds--a figure that rises to 60% in plans with more than $200 million in assets, according to Bob Wuelfing, president of Access Research Inc., a consulting firm specializing in 401(k) plans. Wuelfing says equity index funds are high on the list of features plan sponsors hope to add to their programs.

For sure, what has put indexing in the limelight again is that it has been so successful (table). In 1995, just 29% of the "active" managers--those who pick stocks the old-fashioned way--beat the S&P 500, according to SEI Corp. Mutual-fund managers did even worse: Only 8% of the diversified U.S. equity funds bested the index last year, according to Morningstar Inc. The stock-pickers' returns are better over the longer periods, but not by much.

ADDED ATTRACTION. Bull markets come and go, but index funds have more enduring attributes. Mainly, they're cheap to operate. Big pension funds pay 1 to 2 basis points a year, or 0.01% to 0.02% of assets, as a management fee, vs. 0.40% to 0.50% for active management. L. Robert Frazier, assistant treasurer for asset management at Kimberly-Clark Corp., estimates the company's pension plan should save about $100 million in fees over the next decade through indexing and enhanced strategies. Ninety percent of Kimberly-Clark's $2 billion pension fund is indexed.

There are other savings. Since index funds don't trade much, they incur few commission and market-impact costs. When they do trade, it's mainly in large liquid stocks, where costs are the lowest. In the case of mutual funds, indexing has an added attraction: Because they don't trade stocks, there are few if any taxable capital-gains distributions. Almost all taxes are deferred until the shareholder cashes out.

Indexing has its critics, of course. Investment consultant James Hamilton of Hamilton & Co. warns that index funds look good because of the favorable market conditions. When the market drops, they offer no cushioning. "They've got a big, unprotected downside," he warns. "They've been able to ride out the bear markets because the bear markets have been short. What if you get a two-year bear market like we had in the 1970s?" He still believes that smart, active managers will best the index funds any day.

No doubt the big pension funds will continue to search for market-beating managers. But they'll be more wary about which managers they place their bets on. With indexing an attractive alternative, they can afford to be choosy.

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