FOOL ON THE HILL
Objecting to Index Funds

Lately some have questioned whether index funds -- specifically those tied to the S&P 500 -- are a good place for large portions of an individual's portfolio. But if you're invested in an index, take heart. They're still great vehicles for anyone who wants to participate in the market.

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By Rex Moore (TMF Orangeblood)
February 7, 2002

If you're at all familiar with The Motley Fool, you know we're big believers in index funds. Not everyone has the time and energy that's required to become a successful stock picker, and index funds allow individuals to effortlessly participate in the market while achieving returns that beat the majority of managed mutual funds.

Lately, however, some in the financial press have taken shots at index funds. The boldest may have come from Chris Pummer at CBS MarketWatch, who counsels anyone with more than 20% of their portfolio in an S&P 500 fund to lighten up. In fact, Pummer says those heavily invested in such a fund "could greatly undermine their returns in the coming years." Say what?!

One of Pummer's criticisms is that the funds have not lived up to one of their major selling points, "relative invincibility." In order to discuss this point, we'll have to take a step back to make sure we're working from common ground.

There are many types of index funds, each of which tracks a particular segment of the market. A Dow 30 index should mirror the performance of the Dow Jones Industrial Average, for example, while the Russell 2000 index tracks 2,000 small-cap companies. Other indexes, like the Wilshire 5000, attempt to track the performance of the "total market."

At The Motley Fool we have, in general, used the S&P 500 as a benchmark against which our returns are measured. Why? Because it consists of 500 of the most widely held companies in the U.S., with over $10 trillion in total market cap, and is representative of the market as a whole. If we can't beat that benchmark over the long term, we might as well save our time and energy (and money) and just invest in the benchmark itself.

Why not use the Wilshire 5000 or the Vanguard Total Stock Index as a benchmark? Indeed, we could, and they would be valid benchmarks. But the S&P 500 is well known and is used by nearly everyone as a proxy for the market. ("Stocks drifted lower today, with the S&P 500 falling 8 points, and the Dow down 30.")

Which brings us back to the "relative invincibility" discussion. This is the first time I've even heard this term in relation to the S&P 500. Invincibility is certainly not anything we expect from a market proxy. In fact, all we expect from it is relative "averageness" because it is, after all, the market average.

While we know the S&P 500 has outperformed the majority of managed funds over the long haul, Pummer says more than 60% of managed funds have topped the S&P 500 since the bear market began in 2000. And from the 1964 to 1982 period, when the Dow finished flat except for a 4.8% average annual dividend, managed funds returned about 8.5%. From that, he concludes that the S&P 500 index could be a "disastrous" choice, even over the long term.

That's certainly an odd statement, and if it causes people to exit index funds in favor of managed mutual funds, it could be disastrous in its own right. We've said it before, and we'll say it again: Managed mutual funds have much to overcome in order to beat their targeted indices. Salaries for the managers and their staff, research costs, trading costs, etc., all add up to far more expenses than required by passively managed funds. In the long run, depending on whom you listen to, index funds will outperform 75%-90% of actively managed funds.

William F. Sharpe, who won the Nobel Prize in Economic Sciences in 1990, published a paper in 1991 called "The Arithmetic of Active Management." In it, he mathematically showed how difficult it is for an actively managed fund to outperform a passively managed one. While "it is perfectly possible for some active managers to beat their passive brethren..." Sharpe says, "properly measured, the average actively managed dollar must underperform the average passively managed dollar, net of costs. Empirical analyses that appear to refute this principle are guilty of improper measurement."

And here's an equally important point: Even if you buy the argument that the S&P 500 will struggle against managed funds in a flat or down market, you'd have to be a market-timer in order to take advantage of this knowledge. If we were expert market-timers, however, there would be far greater ways to profit than putting our money into managed mutual funds -- especially in a down market. But it's a moot point, because no one can consistently time the market.

So no, our position has not changed. We still firmly believe that an index fund that tracks the S&P 500 or the total market is a fine place for your money. Some of your money, or even all of your money that you have decided to allocate to the market.

If you've been taught well, you know that nothing is certain when it comes to investing. But going with the index funds stacks the odds in your favor, and you don't have to start shopping around and researching mutual funds and trying to figure out which of those may have a shot of beating the market. And you don't have to worry about a lot of other things, too, like which sectors will be hot over the next year or whether telecomm stocks will bounce back or whether Alan Greenspan will hiccup and upset the markets or whether an NFC or an AFC team wins the Super Bowl.

As Jason Zweig wrote in a CNN/Money column, indexing lets you say "seven magic words: 'I don't know, and I don't care.'" If you don't have the time, inclination, knowledge, or energy to research individual stocks or mutual funds, that's okay. Index funds are a great way for you to participate in the market.

After years of exhaustive research, Rex Moore has determined that a stitch in time actually saves only 8.9997. He's now looking to unload several tons of empty wooden spools. The Motley Fool's disclosure policy goes well with red wine, preferably a complex Merlot, dry and full bodied.