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Stacking the 'Dex

By trying to pick only the best stocks in a particular market measure, companies seek to offer the index-fund investor a better return.

March 11, 1997|RUSS WILES | Russ Wiles, a financial writer for the Arizona Republic, writes frequently for The Times

Most mutual fund companies have an ambivalent attitude toward market "index" portfolios. Although they're increasingly popular among investors and comparatively inexpensive to run, it's difficult for firms to set their offerings apart from those of their competitors.

Fund firms can try to compete on the basis of cost--low expenses, of course, are part of the point of index funds, which aim to replicate the performance of a major market index, usually the blue-chip Standard & Poor's 500, by simply holding the stocks that make it up.

But few fund companies are willing or even able to cut costs in order to compete directly with Vanguard Group, the firm that has become synonymous with low-cost index investing and which manages the $35-billion-asset Vanguard Index Trust 500 Portfolio, granddaddy of index funds.

So instead, several fund sponsors are trying to compete on the prospect of enhanced return by introducing pseudo-index funds that try to cherry-pick the best stocks in a particular index.

For example, Merrill Lynch and four other large brokerages offer several such hybrids. In January they unveiled their latest, the Select S&P Industrial Portfolio. It doesn't track the full S&P 500 but rather invests in 15 high-yielding industrial stocks that meet certain size and financial-strength criteria.

This approach is "a step beyond indexing," reads the brochure for the fund, which also is sold by Smith Barney, Prudential, Dean Witter and PaineWebber.

"Indexes can be beaten if you have the right strategy," said Jeff Glattfelder, new-product manager for Merrill in Princeton, N.J. "We believe dividend yields are a good way to select stocks."

Had such a fund existed in the last two decades, Glattfelder says, it would have delivered 17.1% a year on average over the last 20 years, after deducting fees, beating the 14.2% yearly gain on Vanguard's Index 500 fund.

Actually, the Select S&P Industrial Portfolio is technically not a mutual fund but rather a sibling product known as a unit investment trust. That structure helps shave the fund's operating costs to a respectable 0.38% a year, although investors still face a 1% sales charge at the time of purchase, plus as much as a 1.75% deferred sales charge when they sell.

The brokerages have been offering six other pseudo-index funds, the most popular of which is a unit trust that buys the 10 highest-yielding stocks in the 30-stock Dow Jones industrial average--the so-called Dow dogs.

Two regular mutual funds with a similar slant have also been introduced recently. The Hennessy Balanced Portfolio ([800] 966-4354, no load) in Novato, Calif., splits its assets between the 10 Dow dog stocks and Treasury bills. The Payden & Rygel Growth & Income Fund ([800] 572-9336, no load), based in Los Angeles, invests half its assets in the Dow dogs and the rest in stocks that replicate the S&P 500. (Both the Hennessy and Payden & Rygel portfolios must hold more than just the 10 Dow stocks to meet the minimum-diversification rules that apply to regular mutual funds.)

Another example of a new pseudo-index portfolio is the Boston-based AARP U.S. Stock Index Fund ([800] 322-2282, no load), which aims to perform in line with the S&P 500 but with less risk. The fund, which made its debut in February, features a moderate yield tilt toward dividend-paying companies in the S&P. It also cherry-picks in another way--by avoiding tobacco stocks.

Other new index portfolios are taking different tacks. Fidelity Investments of Boston ([800] 544-8888), for example, plans to unveil three no-load Spartan index funds within the next few weeks that will carry fees almost as low as Vanguard's. The catch is that each Fidelity fund will require a hefty $25,000 minimum investment so as to keep out small shareholders, who are relatively costly to service. Vanguard ([800] 662-7447), by contrast, requires a $3,000 minimum on its Index Trust 500 fund, although the firm imposes a $10 yearly fee on accounts with balances below $10,000.

The Fidelity funds will target non-S&P 500 areas, where Vanguard isn't so dominant. The Spartan Total Market Index portfolio will try to replicate the performance of the Wilshire 5,000 index, which, despite its name, covers 7,000 U.S. stocks, thus offering a way to "buy" the entire U.S. market. (Vanguard has a similar fund.)

Meanwhile, Spartan Extended Market Index will replicate the Wilshire 4,500 index, which holds all of the stocks in the Wilshire 5,000 except the S&P 500 issues--thus offering an index portfolio for mostly smaller stocks.

Finally, Fidelity's Spartan International Index will invest in foreign stocks that make up the Europe, Australia and Far East index tracked by Morgan Stanley Capital International.

Will pseudo-index funds deliver better returns than you'd earn simply holding the S&P 500 over the long run? Maybe. But by definition, tweaking an index adds an element of "active" management to the portfolio--which is exactly what many index fund buyers are trying to avoid, if they're merely looking for a passive vehicle that is guaranteed to track the market over time.

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