Investors Put Index Funds, if Not Their Theory, Into Practice

Twenty-five years after “Saint Jack” Bogle launched his crusade for so-called index investing, many investors have finally found religion.

Now the question is, are the fanatics running away with the concept?

Saint Jack is the industry nickname for John C. Bogle Sr., a founding father of the $6-trillion mutual fund industry and former chairman of Vanguard Group, now the nation’s second-largest fund company.

For the last quarter of a century, using Vanguard as his pulpit, Bogle has preached the gospel of indexing: investing via a portfolio that simply seeks to match the return of a particular market index by buying and holding all of the securities that make up that index--for example, the Standard & Poor’s 500 index of blue-chip stocks.

Why settle for an index return (by definition, an average return)? Because, Bogle argued, given fund expenses and the vagaries of individual stocks, most people cannot beat “the market” in the long run.

Vanguard Group, formed 25 years ago last Friday, introduced indexing to retail fund investors with the launch of the Vanguard Index 500 fund in August 1976. In the 1970s, indexing was widely considered heresy, a fringe investing strategy. So much so that in 1972, Pensions & Investments magazine awarded its “Dubious Achievement Award” to the Boston-based firm Batterymarch Financial Management for even espousing indexing’s virtues.

Today, indexing is one of the few “hot” segments of a tepid fund industry. In July, nearly one of every two new dollars invested in stock and bond funds went into an index fund, according to Financial Research Corp. in Boston.

Vanguard Index 500 now has $91 billion in assets, second only to the Fidelity Magellan fund in size and gaining fast.

But the soaring popularity of index investing over the last few years isn’t necessarily because investors are buying into the “efficient market theory,” indexing’s intellectual underpinning which states that markets are so efficiently priced, it’s futile to try to beat them.

“It may be more pragmatic than that,” says Walter Good, co-author of “Index Your Way to Investment Success.” “People like to buy winners. When Magellan was doing great, everybody wanted to invest in that. Now that Vanguard 500 and other index funds are doing great, that’s what people want.”

Indeed, the S&P; 500 has performed so well in recent years that the average S&P; 500 index fund has trounced the average actively managed stock fund over almost every time period: one year, three years, 10 years and 15 years.

Not surprisingly, assets in index funds have ballooned from $4 billion in 1990 to nearly $270 billion today. That represents nearly a 68-fold rise. By comparison, total mutual fund assets have risen about sixfold--from $1 trillion in 1990 to $6 trillion today.

Yet index fund assets still represent only 10% of total U.S. stock fund assets. But that market share may soon soar, analysts say, with an explosion of new index securities.

Beyond S&P; 500 index funds, Americans can now invest in funds that track the Wilshire 5,000-stock index; the Standard & Poor’s 400 mid-cap stock index; the Russell 2,000 small-stock index; the Morgan Stanley Capital International European, Australian and Far Eastern index of stocks; at least one Internet stock index; and many bond indexes.

In addition, investors can now index through so-called basket securities, unit investment trusts or exchange-traded funds that hold all the stocks in a specific index, such as the S&P; 500, Dow Jones industrial average, or even a single-country stock market index.

Exchange-traded index funds, most of whose shares are bought and sold on the American Stock Exchange, are hybrid securities that exhibit some of the traits of an open-end mutual fund like the Vanguard 500, and some of the traits of traditional closed-end portfolios.

With closed-end funds, however, there are two share prices: one that represents the true value of the underlying portfolio, and the market price of the security, which can be far above or below the true portfolio value depending on investors’ interest, or lack thereof.

By contrast, shares or units of the hybrid index funds are designed so that their prices always closely track the true value of their index.

“Diamonds,” for example, are Amex-listed basket securities that hold all the stocks in the Dow Jones industrial average. Each unit or share of a Diamond is priced at one one-hundredth of the Dow. So if the Dow is at 10,500, you know your shares are worth about $105 a piece.

Barclays Global Investors is betting that that simplicity will spur investor interest. Earlier this year, the San Francisco-based money manager filed registration statements with the Securities and Exchange Commission to launch 51 new exchange-traded index funds, tracking everything from the Dow Jones “consumer non-cyclical sector” stock index to the Standard & Poor’s/Toronto Stock Exchange 60 index of the largest and most liquid Canadian stocks.

Is this the “triumph of indexing” that Bogle has long trumpeted?

To the extent that investors are embracing indexing’s virtues, yes. But to the extent that investors are drawn to narrow index products, “I’d call that a defeat,” Bogle says.

“This whole proliferation of global index funds and exchange-traded index funds is a big marketing gimmick,” says Bogle, a vocal critic of many fund industry practices. “Indexing is a buy-and-hold strategy. Is anybody going to buy and hold Malaysia forever?”

Mark Riepe, head of the Schwab Center for Investment Research, says the growth of narrow market indexes begs a philosophical question: “When you think of indexing, you think of getting exposure to broad core market indexes that are representative of a critical asset class,” he said. “Buying the Dow Jones medical technology sector index doesn’t exactly meet that standard.”

Why would someone buy such a narrow index fund? “To try to beat the market,” Riepe notes. But, he adds, once an investor does that, he or she defeats the original purpose of indexing. At that point, the index investment is no different than a market sector fund.

Exchange-traded index funds differ from traditional index funds in another key way: They allow investors to trade in or out of the securities many times a day, not just once a day at the market’s closing prices.

That means you can now “short” various market indexes. In addition, basket security shares can also be bought on margin and day-traded to your heart’s desire.

“It’s a basis for trading, not buy-and-hold investing,” Bogle says. “Instead of gambling on one stock, though, it allows you to gamble on a group of stocks.”

That criticism isn’t entirely fair, says Morningstar analyst Frank Stanton, at least in the case of S&P; depositary receipts, or SPDRs--securities that track the S&P; 500 and trade on Amex.

He notes that SPDRs can sometimes be more attractive to buy-and-hold investors than even a traditional S&P; 500 index fund. For instance, with an annual management expense ratio of 0.18%, SPDRs are actually cheaper to run than the average S&P; 500 index fund, with expenses of 0.55%.

Meanwhile, whereas Vanguard index funds require a minimum initial investment of $3,000--and levy fees on accounts with balances under $10,000--SPDRs don’t have such requirements. Nor do SPDRs make annual capital gains distributions, like funds.

Still, investors in more narrowly focused exchange-traded index securities should keep in mind that liquidity could become an issue, analysts warn: With index mutual funds, the fund company is always there to redeem your shares at market value. With exchange-traded securities, a seller needs a buyer on the other end--not a problem most of the time, but a risk in a market crunch, at least with the most narrowly focused such securities.

Is this new wave of index securities a natural outgrowth of Bogle’s crusade, or a fad that will pass? For now, the jury’s out--and investors’ long-term returns from these investment hybrids is a big question mark.

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Do you have ideas for mutual fund and 401(k) topics for this column? Times staff writer Paul J. Lim can be reached at [email protected].

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A Blossoming of Index Funds

Indexing is surging in popularity, as evidenced by the proliferation of funds that track all sorts of market benchmarks, from the Standard & Poor’s 500 index of blue chip stocks to the Internet.com index of Net shares. Number of traditional (open-end) index funds at year-end and through August 1999:

1999: 217 funds

Sources: Morningstar