Inscrutable Index Funds

ith the stock market’s rise to heady heights in recent years, index funds—Wall Street’s product du jour—have grown to gigantic proportions. As of October 4, 1999, according to the Wall Street Journal, 37.62% of the year’s new mutual fund investment went into index funds—$44.59 billion for 1999 through August 30. So far it has been easy for investors to ride the wave of index funds. However, since the stock market’s future is always uncertain, index funds are not immune to market fluctuations. Understanding how they operate and their cyclical nature may help CPAs better advise clients or employers about them. The specific investments in a portfolio are as important as how it is managed. Too often investors focus on results rather than on process, so drilling down into how an index fund is managed may yield some surprising revelations about active vs. passive investing.

SAFETY IN NUMBERS?

In trying to grasp the essence of index funds, it’s important for CPAs and other financial managers to understand that neither institutions nor individuals can invest in a market index directly. An index is merely a number, a mathematical construct tied to the price of the stocks that make up the index. An index fund is a mutual fund that buys the same securities proportionately to those in a market index (see sidebar). The only way an investor can participate in index investing is in a derivative manner—owning shares in an index mutual fund that, in turn, owns the stocks dictated by the index.

Who decides what goes into an index? The Standard & Poor’s 500-stock index (S&P 500) tracks the total return of 500 of the largest public company stocks in the United States (400 industrial, 40 utility, 40 financial and 20 transportation companies). The six-member S&P 500 index committee determines the stocks that make up the index. Before 1988, stocks in the index remained unchanged for 30 years. Since 1988, the committee has made revisions when it believes the companies in the index need to be updated to reflect changes in American industry.

Although the focus here is on the S&P 500 index, there are many other stock indexes, including the Morgan Stanley Capital International Europe Australasia Far East (MSCI EAFE), the Russell 2000 and the Wilshire 5000. The MSCI EAFE is an international index that tracks stocks from 21 developed countries. The Russell 2000 measures the performance of U.S. mid-cap and small-cap companies; their average market capitalization is $526.4 million. The Wilshire 5000 was created in 1974 to provide a broad representation of companies headquartered in the United States. Investors can purchase mutual funds that represent these indexes as well as more exotic variants such as a stock-car stocks index fund.

The bottom line is, if it can be measured the financial markets can create an index. (Whether a mutual fund is available is another matter, however.) We have chosen to concentrate our analysis on the S&P 500, and the funds offered by many mutual fund companies that track it, because it represents the largest U.S. companies and is popular with investors around the world.

THE BIG EASY

Many investors sing the praises of index funds. When you consider the recent dominance of indexes such as the S&P 500, what’s not to like? Index fund proponents favor them for a number of reasons. They cite:

High performance. The S&P 500 has consistently outperformed the majority of equity portfolio managers from 1995 through 1998. (Past performance is not a guarantee of future results, though.)

Low expenses. Low stock turnover can result in lower fund expenses. Because portfolio managers do not “pick” stocks, overhead from research and analysis is minimal. Stocks in the index and their corresponding concentration levels are not actively managed. Overall, lower expenses give index funds a head start when it comes to performance.

Tax efficiency. Due to low stock turnover, unrealized capital gains accumulate tax-deferred. Because of this, substantial unrealized gains may accumulate inside index funds. They aren’t recognized until the fund sells shares of a particular stock or the stock is removed from the index and the holdings are liquidated.

Broad market representation. An S&P 500 index fund, for example, represents a broad spectrum of industries.

Adherence to asset classifications. By definition, index funds adhere well to the asset class for which they have been chosen—large-cap, small-cap or foreign—because index funds must mirror the performance of the asset classes they track. On the other hand, actively managed mutual funds are less likely to stay within a particular asset class and style of investing.

Ease. Just click on the Internet and you pretty much know where you stand. Did the S&P 500 go up today? Or down?

However … Although index funds have many of these attributes, hidden dangers lurk. The most significant risk is that of passive investing. Simply stated, buying shares in an index fund is a passive investment strategy that may not provide the portfolio management many clients or companies require. Index fund managers do not actively select stocks for purchase or sale. The fundamental disciplines employed in selecting securities for a portfolio do not apply to the back room operations of an index fund. The stocks in an index fund are chosen by virtue of being on the “A” list.

THE FLIP SIDE

Investing in an index fund may create a personal dilemma. Does the passive character of these funds mean the investor is abdicating responsibilities to an arbitrary measure of the market? Since few investors themselves invest directly in derivatives—put and call options, futures contracts or other derivatives allowed in mutual funds—why would they grant discretionary authority to a third party to do so on their behalf? Furthermore, investors with fiduciary responsibilities are especially vulnerable when investing in index funds. (For more detail on fiduciary responsibilities, see the sidebar above.)

CPAs should be aware that there are several reasons why tying an investor’s portfolio to the ups and downs of an index such as the S&P 500 could prove perilous.

Momentum investing. In a rising market, the index fund’s upward performance attracts investors to buy more shares. This, in turn, causes the fund to invest in more of the stocks that make up the index. Investor expectations become self-fulfilling and create a phenomenon referred to as momentum investing. This occurs in capitalization-weighted index funds when the fund buys more and more of a stock because the stock is getting more expensive. Index fund investors should be concerned about the impact this can have. The self-fulfilling prophecy effect that pushes the price of the index fund upward may manifest itself in a down market, too.

Distortion of past performance. Stocks in the S&P 500 are not selected based on their fundamentals. To preserve the comparability of the index as a benchmark, the committee is very deliberate about changes to its composition. Exhibit 1 , shows how sector weights in the S&P 500 have changed since 1980.

According to Beutel, Goodman Capital Management, in the past 10 years the S&P 500 index has undergone 256 changes—48 of which took place in 1998. Of the 19 stocks added in 1994 the average P/E ratio was 20, and of the 22 added in 1995 the average P/E ratio was 24. The deleted issues had average P/E ratios of 8 in 1994 and 10 in 1995. When measured against earnings, lower-priced stocks were replaced by higher-priced stocks, which can be thought of as an exercise in “reverse economics”—buying high and selling low. Moreover, lack of change in the stocks that constitute the index pays homage to past performance rather than current fundamentals.

Lack of diversification in market capitalization. The S&P 500 index is capitalization weighted; the stocks of the largest companies make up most of the index’s market value. Exhibit 2 illustrates that S&P 500 index funds do not necessarily reflect the broad market’s returns. Simply put, the index provides little diversification in market capitalization. As Winston Churchill said after the Battle of Britain, “Never have so many owed so much to so few.” In 1998, 10% of the issues in the S&P 500 index (the 50 largest stocks) accounted for 87% of the index’s total return for the year. Breaking it down further, 24.9% of the index’s 28.6% return came from the 10 largest stocks. The 15 largest stocks (only 3% of the issues) contributed 51% of the S&P 500’s 1998 return. Exhibit 3 , above, shows the contribution to the S&P 500 made by the top 10 stocks in terms of capitalization through September 30, 1999.

An investment in an S&P 500 index fund might result in too much concentration in only a few stocks. It’s doubtful any investor would abandon basic diversification principals in favor of maintaining a portfolio consistent with the S&P 500. Although professional portfolio managers routinely use the S&P 500 to benchmark their performance, finding an active portfolio manager that invests with a blind eye to diversification is unlikely since a lack of diversification can unnecessarily concentrate risk.

Growth outweighs value. Investing in an S&P 500 index fund does not provide an investor with a portfolio management style. Growth-style stocks rise and fall over a business cycle, usually three to five years. Historically, the more cyclical value-style stocks have sold at lower multiples of earnings and growth; they rise and fall at different times than growth-style stocks. Blending growth and value styles tends to smooth out business-cycle market swings.

Lack of sell discipline. The index approach is inherently passive. Index fund investing is based on momentum, rather than on actively evaluating an investment’s fundamental strengths and weaknesses. In an index fund, more of your investment dollar is allocated to last year’s winners. Capitalization weighting does not rebalance the top performing stocks’ weighting back to that of the prior year to adjust for their performance each year. Passive investing offers no sell discipline, assuring the investor of 100% participation in any down market.

Absence of risk control in a down market. In bull markets, the compounding concentration of capital in a small number of issues works to the investor’s advantage and more aggressively pursues fewer and fewer securities. Exhibit 4 shows the composition of the S&P 500 by capitalization. Even professionals recognize the volatility of the snowball effect of index funds. As George Sauter, manager of the Vanguard Index Trust S&P Portfolio told the Wall Street Journal in January 1996, “The unusually strong performance lately of the S&P 500 funds has brought in ‘hot’ money, which is notoriously fickle. No question, money chases performance—as soon as performance stops, money flees.”

ACTIVE MANAGEMENT

CPAs and other financial managers should never lose sight of the fact that investing is a matter of return and risk. Index funds do not manage risk—only active portfolios do. Active portfolio managers serve clients best by employing a sell discipline that locks in gains and redeploys assets to more attractive opportunities. Exhibit 5 lists active investment strategies that CPAs may want to consider in advising their clients or employers.

CPAs frequently act as a sounding board for clients and employers about which investments to make. Individual or corporate investment policies, as well as investment goals, should determine how and where funds are invested. The specific and unique aspects of these goals define acceptable performance. Knowledgeable, thoughtful and deliberate investment choices will help fulfill investment goals.

Accountability is king. Those responsible for managing portfolios must be held accountable for meeting the investor’s unique expectations. While passive investing may achieve established performance-return criteria, risk-tolerance and diversification goals can be more difficult to meet. Active portfolio managers, on the other hand, focus on the fundamentals and are able to jettison overvalued or underperforming stocks during down markets. Contrast this to an index fund, which holds a specific security until—if ever—it is removed from the index. If index funds sound too good to be true, they just may be.