Index Funds Could Ride a Bull Blindfolded, but What About a Bear?

How will index mutual funds fare in a serious bear market? No one knows, since bear markets are as scarce as Bigfoot nowadays.

The last severe stock market shakeout came in 1973-74, well before indexing caught on with the public. The first index mutual fund wasn’t launched until 1976, when Vanguard Group started its 500 Index portfolio, and most index funds didn’t appear until the 1990s.

Critics of index funds say the characteristics that have propelled these investments throughout the historic ‘90s bull market will make them vulnerable when things get rough. Index funds buy and hold the same companies, in the same proportions, as benchmarks such as the blue-chip Standard & Poor’s 500. This fully invested posture, the reasoning goes, is sure to punish holders during a severe downturn.

Index fund supporters say this criticism is unfounded.

“It’s one of several myths and misconceptions surrounding indexing,” said Gus Sauter, a managing director at Vanguard Group in Valley Forge, Pa., and a speaker at The Times’ third annual Investment Strategies Conference on May 22-23.

Though no index fund has slogged through a slump as severe as the 1973-74 retreat, Sauter says the evidence suggests index funds will hold up relatively well in any major downturn.

For example, during the short but severe crash of October 1987, actively managed funds beat funds pegged to the S&P; 500 and the Wilshire 5,000 by only a percentage point or two, on average. During last summer’s swoon, index portfolios fared a bit better than active funds.

And while index mutual funds weren’t around in 1973-74, the underlying indexes themselves outperformed most actively managed funds during that slump.

“At a minimum, the evidence suggests that index funds won’t be drastic underperformers during bear markets,” said Sauter, who oversees 25 Vanguard index funds with $175 billion in combined assets. And because index funds remain fully invested when the market bottoms, they invariably will lead the recovery, he adds.

Bear market performance isn’t the only misconception that gnaws at indexers. Sauter and other proponents dispute the notion that the tax efficiency of index funds could unravel during bear markets.

Here’s that debate in brief: Because index funds are fairly static portfolios that rarely sell stocks, they pass little in the way of taxable capital gains along to shareholders. As a result, most index funds are sitting on huge unrealized profits that could turn into tax liabilities, critics say, if the managers are forced to sell a lot of stocks to meet shareholder redemptions in a panic.

But index fund managers say they can pursue strategies to minimize the tax impact, such as unloading their least profitable and money-losing positions first.

“In fact, we would sell our high-cost [positions], and we would realize losses, not gains,” said Sauter, who estimates that most of Vanguard’s index funds could sell about 75% of their assets before they would realize net capital gains. “We just don’t think the tax impact would be any big deal.”

Sauter also takes issue with another supposed myth: that indexing doesn’t work well for small stocks. Small companies aren’t researched as widely and closely as blue chips, a fact that would seem to give active managers an advantage in spotting bargains. The common thinking is that talented managers should be able to scoop up enough overlooked small stocks to justify their higher fees. But if there is such an advantage, Sauter says, it’s not big enough to offset the lower costs of index funds in the small-company area.

That sentiment is echoed by David Booth, president and chief executive of Dimensional Fund Advisors, an index fund family in Santa Monica. He says the index cost advantage also applies to foreign stock markets, where trading and research costs tend to be higher than in the U.S.

Booth says active fund managers have routinely failed to foresee foreign crises such as the Mexican peso devaluation of 1994 or the Southeast Asian slump that began in 1997.

“I challenge the assumption that indexing doesn’t work in emerging markets,” said Booth, who also will speak at the Times conference. “In fact, the U.S. is where active managers tend to do best.”

That’s a contentious point, but it’s clear that index funds are feasible in many markets. Consider international exchanges, for example. Foreign mutual funds tracked by Lipper Inc. gained nearly 35% over the five years ended March 31, trailing Morgan Stanley’s unmanaged Europe, Australia and Far East index by 6 percentage points.

What about small-stock portfolios? Their relative performance depends on which index you’re looking at. The typical small-stock fund rose 80% over the last five years, besting the Russell 2,000 by 12 percentage points but falling well short of the tech-heavy Nasdaq composite’s 231% return.

Most people know that domestic-stock funds have had trouble keeping up with the S&P; 500. The index catapulted 221% over the last five years, compared with 134% for the average global-equity fund tracked by Lipper.

Despite any misconceptions, more investors are getting the message that index funds offer compelling benefits. Several fund groups besides Vanguard and DFA offer index portfolios, including USAA, Bankers Trust, Rydex, Charles Schwab and TIAA-CREF, the world’s largest private pension manager, which entered the fund business in 1997.

Meanwhile, exchange-traded index investments such as “Diamonds,” which track the Dow Jones industrial average, and “Spiders,” which replicate the S&P; 500 and its subgroups, have grown in number and popularity. Both are similar to mutual funds except that their shares trade on the American Stock Exchange, allowing investors to buy or sell at various prices throughout the day.

Yet the vast majority of mutual funds are actively managed, an indication that investors still think professional stock pickers can generate superior returns.

“We don’t dispute that most managers don’t beat the indexes,” said Craig Litman of Litman/Gregory Fund Advisors in Orinda, Calif. “But we do believe we can pick good managers who could outperform their benchmarks over reasonable time periods.” Litman/Gregory offers two funds, the Masters Select Equity and International portfolios, both run by half a dozen star managers.

Vanguard’s Sauter, who also manages a couple of active funds that have performed well, nevertheless thinks the odds favor an indexing approach, and he believes expenses are the main reason.

Because index funds hold a largely predictable group of stocks, managers don’t have to spend any time and money on research. Nor can they justify high management fees for what are largely commodity products. In contrast to average stock fund expenses of 1.5% of assets a year, most index portfolios charge less than 0.5%.

“The main reason indexing works in any type of market has to do with its inherently lower costs,” Sauter said.

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At the Conference

The Times’ Investment Strategies Conference, to be held May 22-23 at the Los Angeles Convention Center, features a panel on “Indexing: The S&P; 500 and Beyond.” For registration information, call (800) 350-3211 or visit http://161.35.110.226/isc.

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Index Portfolio Strategies

Many investors view index funds as synonymous with the Standard & Poor’s 500, but in fact you can find many other portfolios pegged to all sorts of market barometers, including those tracking bonds, foreign stocks and sectors. Here are three sample all-index portfolios that could be designed for investors with a conservative, moderate or aggressive posture. Individual funds can be purchased for minimums that range from $250 for TIAA-CREF to $3,000 for Vanguard and USAA. No minimums apply on “Spiders,” which track the S&P; and its subgroups but trade like regular stocks on the American Stock Exchange.

Aggressive Portfolio

Index Fund: Rydex Nova

Target index: Leveraged position in S&P; 500

800 number: 820-0888

Weighting: 30%

*

Index Fund: Rydex OTC

Target index: Nasdaq 100

800 number: 820-0888

Weighting: 30% *

Index Fund: Guinness Flight Wired Index

Target index: 40 tech stocks identified by “Wired” magazine

800 number: 915-6565

Weighting: 10%

*

Index Fund: Vanguard European Stock Index

Target index: Morgan Stanley Capital International Europe index

800 number: 662-7447

Weighting: 10%

*

Index Fund: Vanguard Pacific Stock Index

Target index: MSCI Pacific free index

800 number: 662-7447

Weighting: 10% *

Index Fund: Vanguard Emerging Markets Stock

Target index: MSCI Select Emerging markets free index

800 number: 662-7447

Weighting: 10%

Moderate portfolio

Index Fund: USAA S&P; 500

Target index: S&P; 500

800 number: 382-8722

Weighting: 30%

*

Index Fund: TIAA-CREF Bonds Plus

Target index: Lehman Bros. aggregate bond index

800 number: 223-1200

Weighting: 25%

*

Index Fund: Vanguard Total International Stock Index

Target index: MSCI total international composite index

800 number: 662-7447

Weighting: 20%

*

Index Fund: Vanguard Small Cap Index

Target index: Russell 2,000 index

800 number: 662-7447

Weighting: 20%

*

Index Fund: Select Sector SPDR (“Spider”) Technology

Target index: Technology-stock subgroup of S&P; 500

800 number: Via any broker*

Weighting: 5%

Conservative portfolio

Index Fund: Vanguard Intermediate Bond Index

Target index: Lehman Bros. intermediate government/corporate index

800 number: 662-7447

Weighting: 35%

*

Index Fund: Vanguard Short-Term Bond Index

Target index: Lehman Bros. short government/corporate index

800 number: 662-7447

Weighting: 25%

*

Index Fund: USAA S&P; 500

Target index: S&P; 500

800 number: 382-8722

Weighting: 20%

*

Index Fund: TIAA-CREF International Equity

Target index: Morgan Stanley Capital International Europe/Australasia/Far East index

800 number: 223-1200

Weighting: 10%

*

Index Fund: Vanguard Small Cap Index

Target index: Russell 2,000 index

800 number: 662-7447

Weighting: 5%

*

Index Fund: Select Sector SPDR (“Spider”) Utilities

Target index: Utility-stock subgroup of S&P; 500

800 number: Via any broker

Weighting: 5%

*

Russ Wiles is a regular contributor to The Times and a writer and columnist at the Arizona Republic. He is co-author of “How Mutual Funds Work” (Simon & Schuster, 1997). He can be reached at russ.wiles@pni.com.