Index Investing: The Joys Of Flying On Autopilot

These days, funds pegged to the stocks of S&P 500 are the quickest road to fat gains

It pays very well, but there's not much satisfaction in running a mutual fund these days. No matter how many hours portfolio managers spend quizzing CEOs, dissecting financial statements, and reading research reports, they're probably getting creamed by a fund that automatically buys the stocks in the Standard & Poor's 500-stock index and is managed by a simple desktop computer. At least it took a supercomputer, Deep Blue, to beat chess champ Garry Kasparov.

This year is shaping up as the fourth in a row in which the S&P 500 index makes most managers look like fools. So far, the total return for the S&P 500 is 15.19%, more than twice the 7.55% earned by the average equity fund (through May 30). Toss aside the international and the specialty funds, and the performance doesn't get much better, up only 8.38%. Last year, the index beat 75% of all fund managers. So far this year, the figure is 95%. Fund data are prepared for BUSINESS WEEK by Morningstar Inc.

Not surprisingly, more mutual-fund investors are choosing the no-brainer index fund route rather than search for the few hot-performing funds. About $11.2 billion, or 15%, of the $73.7 billion in cash flowing into equity funds in the first four months of the year went into index funds, according to Avi Nachmany of Strategic Insight, a fund research and consulting firm. In all of last year, some $23.5 billion, or 10.5% of net cash flow, wound up in index funds.

Indexing is even starting to catch on in the bond market. In a tough year for fixed-income investors, the Vanguard Bond Index Total Bond Market Portfolio is up 1.7%. That beats the 1.55% return earned by the average taxable bond fund. In the first four months of the year, that bond index fund took in $1.1 billion--about one-quarter of the net cash flow that went into bond funds.

LOW RENT. Of course, index funds are not new, only newly popular. The Vanguard Index Trust 500 Portfolio, now the second-largest equity fund (table), is 20 years old and has always had a following among B-schoolers and academics who hold that the market is efficient and, thus, that stock-picking is pointless. What also made the index fund attractive was low turnover and very low overhead that shaved 1% a year off the cost of running a fund. In other words, most funds would have to earn at least one percentage point more just to match the index funds. Now, indexing is less an alternative method of investment and "more an opportunistic investment," says Nachmany.

Investors may becoming too sanguine about index investing. That's the concern of the management of Vanguard, which is by far the leader in index mutual funds. Earlier this year, it distributed a report pointing out that passively run index funds aren't always moneymakers, nor do they trump the stock-pickers' funds. Indeed, the S&P index fund underperformed the average fund as recently as 1991, 1992, and 1993.

The reason for the S&P 500 funds' stellar returns has more to do with the success of large-cap stocks than with the philosophical debate of passive vs. active management. The S&P 500 funds are on a tear because the companies that dominate the index are large, successful multinationals that are well positioned to thrive in the global economy. Big-cap stocks are largely responsible for the above-average returns of 9 of the 10 largest equity funds (table). Indeed, at the $53 billion Fidelity Magellan Fund, portfolio manager Robert E. Stansky managed to score a neat 11.29% return.

"A generation ago, these companies would be growing by raising prices and expanding margins," says Jeff Poppenhagen, portfolio manager for Pioneer Growth Shares. "Now, there's little pricing flexibility, so they're using their might to build market share and spread their fixed costs over a large and larger base."

Poppenhagen is one of a few managers to buy the same kinds of stocks as the S&P 500 funds and beat them and even the Vanguard Index Trust Growth Portfolio, which tracks the growth-stock half of the S&P 500. His fund, up 21.40% so far this year, shows that active stock managers of large-cap stocks can outperform the index. Among his major holdings are American Express, Intel, Merrill Lynch, Microsoft, and Nike. Chris Felipe, who runs the MFS Massachusetts Investors Growth Stock Fund, up 19.94%, believes in investors in large U.S. technology companies will be well rewarded. "American tech companies already dominate the global industry, and they're in great position to exploit that."

These big companies, tech and otherwise, are so good at the global game that one mutual fund, Papp America-Abroad, buys them as an alternative to foreign investing. The fund is up 21.38% so far this year, while the more domestically focused L. Roy Papp Stock Fund is up 18.72%. "The U.S. market has the best global companies in the world," says L. Roy Papp, the fund's manager. "So why take on the additional risks of investing in foreign markets?"

Many investment advisers may take issue with that, since most believe bringing non-U.S. investments into a fund portfolio lowers overall risk and raises returns. But so far this year at least, Papp's argument seems persuasive. The returns on international funds are slightly below those of domestic funds.

RUSSIAN ROULETTE. There are some exceptions. Lexington Troika Dialog Russia Fund, investing in perhaps one of the riskiest foreign markets, is by far the best-performing fund of the year, up 59.07%. But that's more a function of the market than stock-picking prowess. The fund is actually trailing the Russian stock market index by nearly 30 percentage points. As a category, Latin America funds are well out ahead of the pack, up an average 24.48%--and nearly 10 percentage points of that in the past two months alone. Thirteen of the top 25 best-performing funds of the year invest mainly south of the Rio Grande. Benny R. Thomas, portfolio manager of the T. Rowe Price Latin America Fund, says strong economic growth, falling inflation, and privatization of state-owned companies are fueling the boom.

At the other end of the spectrum are the precious metals funds, down 10.78%. They lost nearly 3% in the first quarter, mainly because of a lackluster gold market. What knocked them down since was the revelation that Bre-X Minerals Ltd.'s gold strike turned out to be a scam. That even hurt the likes of the Midas Fund, which never owned a share of the now worthless stock. "The effect was to drag down all the junior mining stocks, even those with excellent management," says Kjeld R. Thygesen, who runs Midas. "Now, gold is cheap and the stocks are cheap, which makes the fund a good buy."

LATE SPRING. Of course, that's a typical response of a manager whose fund is in a slump. And that's the argument heard from those who run mutual funds that focus on small-cap stocks. Small-cap growth stocks, especially tech stocks, have been in a vicious bear market for 12 months (table, page 129) and are starting to pick up. Strong Small Cap Fund is down 12% so far this year, but it's up 17% in the past five weeks. Likewise, Van Wagoner Micro-Cap Fund is off 11.16% since January, but it's up 23% since the late April bottom.

For sure, many fund managers and fund watchers have called the end of the small-cap bear market before, only to be disappointed. But money is starting to come back. About one-quarter of the cash flowing into equity funds in the past three weeks went to funds that invest in the riskier small-cap stocks, says Robert Adler of AMG Data Services, an Arcata (Calif.) firm that tracks money in and out of funds. And since investors tend to chase performance, strong returns from small-cap funds will likely draw in more money and further fuel the rally. "Small-caps should rebound for at least the next three to six months," says Robert Natale, editor of Standard & Poor's Emerging & Special Situations, a newsletter that follows small-cap stocks.

There's not much of a rebound going on among the beleaguered bond funds. True, yield on the benchmark 30-year U.S. government bond, at 6.9%, is down from nearly 7.2% in early April. But it's still markedly higher than the 6.6% yield at yearend. Since rising rates cut bond prices, most bond funds have suffered losses in net asset value this year. Long-term government bond funds, which are the most sensitive to rising rates, are flat for the year. Ultrashort bond funds, which have maturities not much beyond that of money-market funds, earned 2.13% total returns. The muni funds looked little better. They earned an average of 1.51%.

That's not the sort of performance that's going to bring cash back to bond funds. To most investors, even an equity fund that lags the S&P 500 is going to look at whole lot better.