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The active approach to passive investing
Supposedly simple index funds in fact require real study, unless you don't mind sitting idly while a bear gnaws at your returns. You can capture the efficiency and ease of indexing with less expense and risk.
By Timothy Middleton
Portfolios designed to track popular market indexes were supposed to take decision-making out of investing. But their proliferation actually has put it back in.
Morningstar says there are more than 300 mutual funds indexed to such benchmarks as the Standard & Poor's 500 ($INX) and the Lehman Brothers Aggregate Bond index. One of the nations largest fund complexes, Vanguard Group, is best known for indexing, and another, Dimensional Fund Advisors, is entirely committed to this so-called passive investing approach.
By owning the index, youre sure of getting index-type returns, which will be better than 80% of other investors, says David H. Bugen, a partner in Regent Atlantic Capital, a Chatham, N.J., financial advisory firm.
That 80% figure applies to Vanguard 500 Index (VFINX), which during the 1990s outperformed four out of five mutual funds investing in large-capitalization stocks. In the process, it became the largest equity fund in the country, overtaking famed Fidelity Magellan (FMAGX). (Magellan is actively managed, meaning that its manager picks stocks to buy and sell.)
The success of S&P 500 funds spurred interest in hordes of others, and today you can index almost anything, from foreign stocks to commercial real estate. You can also buy so-called enhanced index funds, which juice returns by tweaking their mix of holdings.
Up next, exchange-traded funds
Most recently, you can index using exchange-traded funds, or ETFs, a cross between mutual funds and common stocks. In addition to all the common benchmarks, some ETFs track sectors, such as the iShares Dow Jones U.S. Healthcare (IYH, news, msgs), and even industries, as with iShares Goldman Sachs Semiconductor (IGW, news, msgs).
But lurking among the welter of index funds in the marketplace are plenty of duds. There are some indexes you would not want to own, says Mark Hebner, president of Index Funds Advisors, investment counselors in Irvine, Calif. One example: The Nasdaq 100 ($NDX.X), the riskiest stocks in the marketplace. Another: The Russell 2000 ($RUT.X), a small-stock benchmark flawed by its design.
Vanguard Group is the mother church of indexing in America, offering a score of funds that offer exposure to all the broad markets. In addition to the flagship 500 portfolio, these include Vanguard Total Stock Market Index (VTSMX), Vanguard Balanced Index (VBINX) and Vanguard Total Bond Market Index (VBMFX).
From a finance professor's point of view, these funds approach perfection. The theory holds that there is so much information available to all investors these days that nobody can know enough about enough individual securities to be a shrewder shopper than any other.
Indexing is also extremely cheap as a strategy, and add tax efficiency to the bargain, because theres little trading. The expense ratio of Vanguard 500 is 18 basis points, or hundredths of a percentage point. The average equity fund charges 150 basis points, meaning it has to generate gross returns more than a full point higher than Vanguard just to equal its net return.
Exposing the risk
These are generalizations, of course: Warren Buffett consistently beats the market, and he does it with less risk than the market itself. The bear market exposed the risk inherent in indexing. It boldly goes where good sense says do not. Over the last three years, fully half of large-cap mutual funds beat Vanguard 500.
Plenty of other index funds do worse still. Vanguard Pacific Stock Index (VPACX) is so dominated by Japans wretched market that it has lost an average of 1.4% in each of the last 10 years. Vanguard Small Cap Index (NAESX) is regularly beaten by two-thirds of active small-cap managers.
The small-cap fund is the victim of having to follow a lousy benchmark. William J. Bernstein, author of "The Intelligent Asset Allocator," notes that the Russell 2000 is rebalanced every summer to include the 1,001st through the 3,000th U.S. stock ranked by market capitalization.
Any boob can anticipate which stocks will be added to the benchmark on June 30, meaning all those index funds will have to buy them, meaning they will go up. So funds indexed to the Russell 2000 are doomed to buy high. And when stocks are dropped from the index, they also sell low.
Aiming for a better approach
Indexers recognize the limitations of their strategy, and theyve taken two tacks to get around them. One is enhanced indexing, which is the specialty of the small TIAA-CREF family of mutual funds.
TIAA-CREF Bond Plus (TIPBX), for example, largely follows the Lehman Brothers Aggregate Bond Index, but the manager is free to use about a quarter of the fund's assets to make bets that certain segments of the bond market will outperform others. Last year, for example, manager Lisa Black put more than 10% of the funds assets into Treasury Inflation Protected Securities, which had a banner year.
The other tack is to design better benchmarks. This is the forte of Dimensional Fund Advisors, a family of funds that follow indexes created by finance professors. DFA International Value (DFIVX) consistently ranks in the top quartile among foreign-stock funds, despite having large holdings in Japan.
As Ive noted in this column before, the only problem with DFA funds is that theyre hard to buy, because the company screens out investors it doesnt like. The usual entry is to hire a financial adviser whos already on the companys preferred list.
Exchange-traded funds have portfolios created exactly like traditional index funds, but they trade like common stocks. There are roughly 80 of them, most belonging to the iShares group, which is managed by Barclays Global Investors. Vanguard is better known as an indexer, but Barclays is larger.
ETFs are analogous to closed-end funds, except their design eliminates discounts and premiums, which haunt closed-end funds. ETFs can be created and destroyed at the institutional level by buying or selling baskets of the underlying securities, so they hew to their net asset value.
Because they trade like stocks, ETFs can be used by traders to place bets on market moves. But their principal appeal is to long-term investors, because their annual expenses are rock bottom. For example, iShares bond funds have expense ratios of only 15 basis points. The nations largest bond fund, Pimco Total Return (PTTAX), charges 90 points. Sector funds, like iShares Dow Jones U.S. Technology (IYW, news, msgs), charge 60 points; Fidelity Select Technology (FSPTX) charges 113 points.
These economies are denied to investors who dollar-cost average or otherwise buy in small quantities. If you invest $3,000 in Vanguard Total Stock Market, all $3,000 goes immediately to work. If you choose (iShares Dow Jones U.S. Total Market Index, IYY)), you could buy 70 shares at the Jan. 2 closing price of $42.27, pay $30 in commissions and have $11.10 left over. Only $2,958.90 was actually invested.
A better strategy
So a better strategy for owning ETFs is to maintain a mutual fund account for systematic contributions, and then, from time to time, to move significant sums into ETFs.
The only ETF I would never consider is the most famous one -- the QQQ, for the Nasdaq 100 Trust (QQQ, news, msgs). It offers a cruel double measure of risk; the blindness inherent in indexing with the lameness of a market singularly prone to hype and panic.
It went down 39% last year, nearly twice as much as the overall market. That followed declines of 33% the prior year and 36% the year before that.
But it can be safely ignored. Theres plenty more to choose from in the expanding world of indexing.
At the time of publication, Timothy Middleton owned or controlled shares in the following securities mentioned in this article: Vanguard Total Stock Market Index Fund.
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