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INVESTMENT STRATEGIES: AN INVESTOR'S PRIMER AND GUIDE
TO THE INVESTMENT STRATEGIES CONFERENCE MAY 22-23

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

May 11, 1999|RUSS WILES | SPECIAL TO THE TIMES

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.

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