Is it a Nifty 500? Part II (Harry Jones) August 26, 1999

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Is it a Nifty 500? Part II

By Jim Surowiecki

(August 26, 1999) -- We continue from Part I, which ran last week.

Some folks worry that index funds are laying the groundwork for a decline similar to the early 1970s debacle. Since mutual funds in general are so flush, and redemptions don't seem to be rising, index funds are seen as exacerbating the dangers of overvaluation. And since other investors know that the indexes are going to be buying S&P stocks, investing in those companies becomes a smart play; it's not just that the indexes themselves are inflating prices with their purchases, but that the commitment of these funds to those stocks almost certainly provides a floor below which they will not drop.

Magnifying the impact of the S&P index funds is the fact that large corporations have generally done better and earned more during the second half of this decade than have their smaller competitors. Earnings for the biggest American corporations have been almost uniformly impressive (excepting Coca-Cola, Gillette, and a few others). After all the rhetoric about how small, nimble companies would be better able to adapt to the new global economy, we seem to be facing the reality that a well-managed multinational is able to leverage global markets -- of which there are now so many more -- better than anyone else.

Stock prices should, after all, follow earnings, and in that sense the relatively steep rise in the proportionate value of the S&P 500 is simply what should be expected. And to connect that rise with index funds themselves is confused, since there are now a multiplicity of such funds available, with indexes of almost every imaginable stripe.

Still, the fact that index funds have become one of the primary vehicles of choice for new investors does say something important about the way mutual fund investors see the market, namely, as the source of near-guaranteed returns. It's difficult to find a single survey of mutual fund investors that suggests differently, and most such surveys indicate that investors believe that the market will return something like 15% annually for the next ten years, a rate that until this bull market was unimaginable.

In that sense, something like a Nifty 500 may be in the process of being established, whereby investors come to take the S&P index as a proxy for the market as a whole, and in doing so inflate the prices of the stocks in that index. Intel and Microsoft, for example, have at times accounted for nearly half of the Nasdaq market's rise. And the lack of interest in small caps reflects not only weaker earnings but also the authority that index funds have come to exercise.

The fear is that a couple of quarters of slower economic growth or weak earnings could lead to a sharp rise in redemptions, and that in turn would crash the entire index. This doesn't seem completely unreasonable, but the reality of the last few years is that we have been in the midst of a very jumpy market, and yet there is no indication that mutual fund investors have begun to panic. More than that, it's not exactly clear how real the impact of index funds is on the index. Intel and Microsoft are owned by many more funds than the indexes, and the latter reap the benefits of the former.

The irony of Burton Malkiel's recommendation is that index funds would be taken up and advocated by value investors in the decades that followed. The simplicity and safety of index funds made even those who believe that it is possible to beat the market advocate them for investors who are unwilling to do the research necessary to be a successful investor. And the great virtue of the index fund, from the perspective of value investors, is that it keeps people aware of one simple fact: Over the long term, the market rises. In a universe of mutual funds -- 70% of which don't beat the market averages -- being at the market average is nothing to dismiss.

[Please note, this column was originally published on February 12, 1997.]


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