Along For The Ride

To index or not to index? In the financial markets of the '90s (the recent market correction notwithstanding), where some investors seem to think that double-digit returns are a right, many question not whether they should invest in an index fund but whether to invest in anything else.

In search of the highest returns, fans of index funds would point out that figures don't lie: According to statistics generated by Kevin McDevitt, mutual fund analyst at Morningstar Inc., for the past three years, the S&P 500 Index landed in the top 7 percent of all large-company funds; for the past five years, the top 7 percent; for the past 10 years, the top 13 percent; and for the past 15 years, the top 8 percent. Although past performance is no indication of future returns, don't think investors haven't noticed the results: Over the past five years, they've poured billions of dollars into index funds.

Although these funds may have a place in your portfolio, before you become complacent, understand where your money is going. There's a lot to know about index funds.

Lorayne Fiorillo is a financial advisor and first vice president of investments at Prudential Securities Inc. Past performance is no guarantee of future returns. For more information, write to Lorayne in care of Entrepreneur, 2392 Morse Ave., Irvine, CA 92614.

More Than Meets The Eye

What makes funds that track the S&P 500 so popular?

1. It's virtually impossible to lag the market. Index funds either mirror their benchmark index or comprise a group of stocks that are close to the underlying index. Unlike their managed brethren, there's no chance the fund manager will misread the market's cues and concentrate funds in a sector just as it unravels. On the other hand, index funds don't offer opportunities for savvy managers to overweight a portfolio in an undervalued sector that will be the next to take off.

2. Low cost. Index funds are notoriously cheap. Since portfolio turnover occurs only when stocks are added or dropped from the underlying index, trading costs are low. Investment management fees are also generally lower than actively managed funds.

3. Lower taxes for some investors. Low portfolio turnover may make index funds more tax efficient than some managed funds whose portfolios are changed more often. Check the prospectus and consult your tax advisor for more information.

At first glance, all index funds might seem the same, but you never know until you take a look. Investing in an index fund seems like pure investing, right? Wrong. Contrary to popular belief, investors can't invest directly in an index. And the index fund you're interested in may not be what you think.

My informal poll of 25 investors showed that each of them thought an investment in the S&P 500 was equal to an investment in the 500 largest companies in America. Actually, the S&P 500 Index consists primarily of 500 domestic stocks and is capitalization- weighted, meaning larger stocks are more highly represented than smaller equities. Because of this weighting, the index's movement reflects the movement of the largest issues. Included in the S&P 500 are the stocks of 378 industrial companies, 75 financial companies, 37 utility companies and 10 transportation companies. Since mid-1989, this composition has been more flexible, and the number of issues in each sector has varied.

In all, the S&P 500 represents only about 70 percent of the U.S. stock market, so its performance doesn't reflect that of the entire stock market. What does its weighting do to the index's performance? Because large businesses get a higher proportion of incoming investment, the stocks of companies like Coca Cola, General Electric and Microsoft, for example, have a weighting that's much higher than the stocks that are at the bottom in terms of market capitalization. Thus, the increase in the value of the S&P 500 becomes a self-fulfilling prophecy: The higher the index goes, the more money it seems to attract; and the more money it attracts, the larger the proportion going into the companies at the top. The higher these companies' stocks rise, the more inviting the index may seem, and the more money goes into it.

In some ways, investing in the S&P 500 becomes a momentum play where investors buy highly priced stocks and continue buying as prices increase, a situation most value investors would shun. Should some of the wind be knocked from the sails of the popular stocks at the top, the resulting fall in the S&P 500 could be sharper than many would have anticipated. For this reason alone, it generally makes sense to diversify beyond this index.

The same is true when considering other indices. The Dow Jones Industrial Average, for example, comprises 30 common stocks chosen by the editors of The Wall Street Journal as representative of the New York Stock Exchange and of U.S. industrial companies. The Dow is also a weighted average; that's why its movements are often so sharp when one large component rises or falls precipitously.

Index funds provide investors with an opportunity to put all their money into the market at one time. They don't hold cash--a nice position to be in when the market is rising, but not a very comfortable perch when stocks are on their way down. Still, if you're a long-term investor, and it's possible to garner high returns with low expenses, why consider using a managed fund at all? "You're looking backward [instead of at] what can happen in the future," says Michael Lipper, chairman of Lipper Analytical Service Inc. in Summit, New Jersey. "And in theory, there is less volatility with managed funds because you have cash--this dampens the volatility in both directions, up as well as down."

Lipper also notes that some managed funds hold larger concentrations of certain industries considered undervalued by their managers, or hold positions in different-sized companies. If large companies stumble and small and midsized firms outperform, then the presence of the latter issues could augment the return of the managed fund in a market downturn. Of course, should large-cap stocks continue to outperform their smaller brethren, the presence of small and midsized companies in a fund's portfolio could lower its return relative to that of a large-company index fund.

Riding In The Sidecar

If you plan to look beyond the S&P 500 to diversify your holdings among stocks of different sizes, why not turn to another index fund? Whether you read The New York Times or Money magazine, you've probably noticed that funds that mirror the S&P 500 have recently been outrunning managed funds in the same sector (those invested in large-cap stocks).

The same is not true of all indices and their respective managed counterparts. McDevitt notes that when dealing with small or midsized company indexes, "The indices perform decently, but there are more small companies to cover and more are illiquid. In these market sectors, active managers can add value."

McDevitt agrees that the S&P 500 is not representative of the entire market. "Investors there have minimal exposure to small, mid-cap, overseas or bond markets," he says. "If all you have is the S&P 500, you have a very undiversified portfolio."

What's a bewildered investor to do? Many investors feel comfortable with part of their portfolio invested in the S&P 500 index. How much is enough? While no one can give blanket advice and each situation is different, Lipper believes that for even the most aggressive investor, no more than 25 percent of a portfolio should be allocated to funds that mirror the S&P 500. In addition to holdings in the index, investors should consider diversifying their portfolios based on their age, temperament, financial goals and tolerance for risk. (For more on risk, see "Personal Finance," October.)

If you're looking for something that's different from the unmanaged index, consider a focused fund. This type of investment allows fund managers to limit their holdings to a few choice picks, anywhere from 20 to 40 stocks in a typical fund. Theoretically, a good stock picker with a select portfolio can produce returns that are substantially better than an unmanaged index over time. Of course, even the hottest stock picker can be wrong some of the time, making this type of fund's return less predictable than that of a broadly diversified portfolio. Lack of diversification makes this type of fund much more risky than the broadly diversified index fund; it's not appropriate for everyone.

To make the most of focused funds, read the prospectus of several and select a few funds with different philosophies that cover different market sectors. Combined with a position in a broad index fund and holdings in different types of securities, you should get the diversification you need to help make the most of your investments.