With Index Funds, Who Needs Gurus?

Before mailing your yearend bonus to a mutual fund run by one of last year's gurus, consider this: Over the past five years, fewer than 5% of all stock-fund managers have beaten the Standard & Poor's 500-stock index.

If that's not enough of an argument for investing in funds that mechanically replicate the blue-chip index, here's another: Over time, index funds tend to outshine 55% of their actively managed rivals, according to Vanguard Group, the nation's biggest manager of index funds. The trend has held true this decade, notes Morningstar. What's more, if you compound index funds' returns over 10 years, they surpass about 80% of their actively managed peers, says Vanguard. "Indexing is not a short-term strategy," notes Vanguard Managing Director Gus Sauter.

Since 1994, funds tracking the S&P 500 have outpaced far more than 55% of their large-cap rivals. In 1998, they beat 73%, compared with 88% in 1997 and 78% in '96. One reason is that the bull market has rewarded index funds for putting every dime to work in stocks, while penalizing managers who hold cash in reserve. Another is that large-cap managers frequently add a few small and midsize names to their portfolios. Those sectors, which have minimal representation in S&P 500 funds, have lagged. Finally, because the S&P 500 is weighted according to market value, it allows rising stocks such as Microsoft to take up an expanding proportion of the index. Many active money managers trim back on winners for fear of becoming overexposed to a single stock.

If the tide turns against big stocks, stock-pickers might have their day again if they can achieve superior performance elsewhere. In that case, the Russell 2000 index of small-company stocks might become the bogey to beat. But in the four years since 1988 that small stocks have fared better than large, managers failed to keep up with the Russell in every year but one.

How has a simple no-brainer approach outmaneuvered some of the best minds on Wall Street? Mainly by offering a cheap way to invest. In theory, an index fund that reflects the entire stock market should beat half of all funds and trail the rest. But when performance is adjusted for fees, index funds become overachievers. While the average fund pockets 1.45% of assets to pay for research, marketing, and managers' salaries, the typical index fund is a lean operation that takes just 0.56%. And many funds are far cheaper. The largest U.S. index fund, Vanguard Index 500, with assets of $69.5 billion, has an expense ratio of just 0.18%.

CHURN-FREE. Brokerage and other trading costs shave almost one more percentage point from returns generated by active managers, who replace an average of 87% of the stocks they own each year, Vanguard says. ndex funds, on the other hand, hold on to stocks until they're kicked out of the index. That was the case recently when Standard & Poor's (like BUSINESS WEEK, a unit of The McGraw-Hill Companies) substituted Safeway, the supermarket chain, for Chrysler, which merged with Germany's Daimler Benz and therefore became a foreign company.

With annual portfolio-turnover rates averaging 21%, index funds also generate fewer capital-gains distributions on which their investors must pay taxes. As a result, almost all capital-gains taxes are deferred until you cash out.

That's not to say managers can't add value. As small stocks have lagged, managers have beaten the Russell 2000 by moving into a few larger stocks. International funds have outpaced the Morgan Stanley Capital International EAFE index (for Europe, Asia, and the Far East) by shunning Japan. But while such maneuvers shield investors from the worst of a bear market, they can prevent them from getting in on the ground floor of a rally. Errant managers may also expose investors to more of a particular asset class than might be desirable. "Your overall asset allocation is more reliable with index funds," says Rex Sinquefield, co-chairman of Dimensional Fund Advisors, an index-fund group.

SMART CHOICES. Although index funds are passively managed, the indexes aren't on autopilot. Take the S&P 500. A committee periodically replaces companies that are fading or acquired with up-and-comers deemed more representative of the economy. A recent example: the substitution of Internet dynamo America Online for struggling retailer Venator.

Indexing has the overwhelming support of academics, who believe the market is so sophisticated that stock prices instantly reflect new information. In this environment, an investor not trading on illegal information has no advantage over others. With the odds of being right at 50% in every transaction, picking stocks that beat the benchmark is no different from correctly calling a coin toss, contends Morningstar research director John Rekenthaler. Accordingly, over time, active managers tend to earn a market return--minus management fees and transaction costs.

Outside academe, this argument is still underappreciated. At the end of the third quarter, nearly 17% of the money flowing into mutual funds was earmarked for index funds. That's up from 3.7% in 1990, but is still only enough to give the category 6% of the market, according to Financial Research, a fund-consulting firm in Boston. Why isn't the concept more popular? Many investors can't resist the temptation to look for the next Peter Lynch. And David Kliff, president of Personal Financial Advisors in Buffalo Grove, Ill., observes that "there is nothing wrong with putting some money into a conservative fund that may capture 90% of an index' gain with less of its risk. That's a fair tradeoff." Kliff also argues that funds run by stock-pickers offer more protection in bear markets.

Still, there is no evidence that managers have been able to anticipate trouble. Before August's sell-off, the average fund had only 5% of its assets in cash. That's less than the 7.1% held, on average, at yearend over the past five years, Morningstar says. Past corrections provide ammunition for both sides. With a few minor exceptions, index funds held up better than their peers as the market gyrated in August. But in previous downturns, including 1987's crash, the situation was reversed.

WASTED ENERGY. In small-cap and international markets, financial planner Harold Evensky believes, it's easier for money managers to make a difference because fewer analysts cover those markets. But when it comes to big-cap U.S. stocks, he suggests that clients stick to index funds. "We like to think that someone with great ideas, brains, and technology can beat the system," Evensky says. "But we kept looking at how our active managers did compared to the index, and the answer was, generally, `Not very well."'

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