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Tuesday, December 29, 1998

FOOL ON THE HILL
An Investment Opinion
by Warren Gump

Indexing Outside the S&P 500

An astute Fool on the message boards recently noted that the Nasdaq 100 has significantly outperformed the S&P 500 over the past ten years, yet more money was flowing into S&P 500 index mutual funds. From the end of 1988 to September 30, 1998, the Nasdaq 100 outperformed the S&P 500 by almost 6 percentage points annually, based on returns of 23.1% and 17.3%, respectively. Why, this reader wondered, would investors be funneling more dollars into the fund with lower performance?

There are several reasons for this phenomenon, but his question elicited an important investing point. There are many indices beyond the S&P 500. While the S&P 500 can be the bedrock of most portfolios, those wishing to devote more time to investing but not interested in individual stocks may find other indices that provide higher returns.

Before venturing into index funds, it is helpful to understand the differences in how stocks are selected for inclusion in the indices and how the indices are calculated. Anyone can create an index to track the overall stock market or specific sectors within the market. Some consist of a large number of stocks, while others are quite limited. Perhaps the best known index is the Dow Jones Industrial Average (DJIA), which is composed of 30 major stocks in various industries picked by the editors at Dow Jones as bellwethers of the U.S. stock market.

The broadest-based index of large companies is the S&P 500. The 500 stocks in the index are selected by Standard and Poor's, based on the company's representation of the U.S. economy, stable financial profile, and liquidity (i.e., high level of trading activity). One of the best performing major indices in recent years is the Nasdaq 100, which tracks the performance of the largest stocks traded on the Nasdaq stock exchange. Inclusion in this index is based on a formula that selects those stocks with the greatest market capitalization (shares outstanding * price per share).

When calculating indices, companies must decide how each stock in it will be weighted. The most popular methodology is based on market capitalization. In an index such as the S&P 500, a stock's weighting is based on the percentage of value of the entire index an individual company comprises. If the market capitalization of a company's stock is $1,000,000 and the market capitalization of all stocks in the index is $20,000,000, the stock would be included as 5% of the index.

The DJIA uses a different methodology -- priced-based weighting. Not surprisingly, this means that the weighting of each individual stock is based on that stock's price relative to the sum of all the stock prices. Assuming that the sum of each stock in a price-based index is $500, a stock trading for $20 would comprise 4% of an index. An unusual impact of such a system is that a stock split has a noticeable effect on a price-based index. If the $20 stock mentioned above declares a 2-for-1 split, ceteris paribus, its weighting would fall to slightly over 2% despite no fundamental change in the companies in the index. For this reason, there aren't too many price-based indices.

The Nasdaq 100 index just switched on December 21 from being a pure market-capitalization based index to a modified market capitalization index. This change will limit the weighting of securities that comprise over 4.5% of the portfolio to increase the portfolio's diversification. This change was implemented because the largest five stocks in the index totaled about 61% of its value. Under the adjustment mechanism, the weighting of these five stocks will be lowered to 40%.

Why should the S&P 500 be the backbone of an indexing strategy? It consists of 500 of the largest U.S. companies across a wide spectrum of industries. The folks at Standard and Poor's who select stocks for the index go out of their way to ensure that the index substantially represents the U.S. economy. Included in this index are car makers, technology companies, pharmaceutical companies, retailers, financial companies, and Internet companies (starting Monday when America Online (NYSE: AOL) joins the index). With such broad diversification across the U.S. economy, the growth in profitability within companies in the index should roughly mirror the overall growth of corporate America's profitability.

The Nasdaq 100, on the other hand, does not have the breadth of the S&P 500. Five stocks, all of them in technology or telecom, make up 40% of the index. In comparison, the S&P 500's top five industries total only 26% of the index. The focus of the Nasdaq 100 is terrific for investors when the included stocks are doing well, but it does not necessarily allow for participation in the overall growth of U.S. corporate profitability. Investing in the Nasdaq 100 is essentially making a bet that the stocks of some large technology and telecom companies are going to outperform the overall market.

There is nothing wrong with having such an investment strategy, but it is quite different from investing in the S&P 500 and the growth in a diverse group of large capitalization U.S. stocks. Before investing in an index such as the Nasdaq 100, you should feel confident about the prospects for the specific sectors that are overweighted in the index. You are not making the less restrictive assumption (implicit with investing in the S&P 500) that the value of corporate America is going to increase over time.

Investing in indexed funds is generally more profitable than investing in actively managed funds with similar objectives because of lower expense ratios and reduced stock turnover. An index fund lowers expenses because it doesn't have to pay fund managers to pick stocks. In addition, the lower turnover inherent in most index funds results in reduced trading costs (not to mention a lessened tax bite for taxable investors). To easily invest in corporate America in one fell swoop, an S&P 500 index is probably your best bet. If you want to invest in more specialized sectors, you can certainly beat that index. Before doing so, however, you should be willing to invest the time to learn about how the index is constructed and the prospects for the stocks of the companies or industries that are emphasized.


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