(June 20) – “It’s the investment equivalent of light beer. Sure, it has fewer calories. But you are still boozing,” writes Johnathan Clements in today’s Wall Street Journal.

“As regular readers of this column know, I am a huge fan of indexing, the strategy of simply buying the stocks that constitute a market index in an effort to match the index’s performance.”

“But there is more than one way to index, and I believe a lot of index-fund investors are hitting the light beer in a big way. These folks are using index funds to make big sector bets, usually on bargain-priced “value” stocks and on shares of smaller companies. What’s going on here? You need to distinguish between buying index funds and matching the market.”

“If you want to track a market’s results, you buy all the stocks in the market, investing a different amount in each depending on a company’s stock-market value. For instance, to mimic the U.S. market, you might buy a fund that replicates the Wilshire 5000, an index that includes almost all regularly traded U.S. stocks.”

“If you do that, you are guaranteed to outperform the collective performance of investors in U.S. stocks who actively manage their portfolios. In aggregate, these active investors own the same stocks you do but they are incurring far higher investment costs, so their collective performance will inevitably be worse.”

“Admittedly, matching the market does involve one judgment call, which is deciding how much to invest abroad. I usually suggest putting 25% of a stock portfolio into a foreign-stock index fund, but reasonable people can differ on what the right percentage should be.”

“Using broad-based index funds to match the market is, I believe, brilliant in its simplicity. But many index-fund devotees, including a lot of investment advisers I admire, aren’t satisfied with mimicking the market.”

“Instead, these folks use index funds as a low-cost way to make sector bets. That has meant a brisk business for Dimensional Fund Advisors of Santa Monica, Calif., and Vanguard Group of Malvern, Pa., both of which offer a slew of specialized index funds.”

“The appeal of these specialized funds is understandable. If you buy, say, a small-stock value index fund, you know you will outperform most active investors who own these same stocks. Additionally, because it is an index fund, you don’t have to worry about the manager straying from the fund’s mandate and buying, say, larger companies.”

“Nonetheless, making sector bets is a risky business and you could end up trailing the broad market. So why are indexers rolling the dice like this? You have to go back to indexing’s roots in academia. Finance professors have long argued that the stock market is efficient and that efforts to beat the market will likely lead to lackluster results.”

“Not surprisingly, indexers pay a lot of attention to what academics say. In particular, indexers have been influenced by two pieces of research. First, there was the 1981 Journal of Financial Economics paper by Rolf Banz, who pointed out that small stocks outperformed large stocks. That was followed by a June 1992 Journal of Finance paper by Eugene Fama and Kenneth French, which detailed superior performance by value stocks.”

“This research has prodded many investment advisers to overweight small companies and value stocks, in the hope of earning market-beating returns. But unlike the academics, many of these advisers argue that this is actually a less risky strategy.”

“‘The main drawback of owning the whole market is that you own more of the stocks that are most richly valued,’ says William Bernstein, an investment adviser in North Bend, Ore. ‘Most of the time, that’s not a real problem, because there isn’t much of a chasm separating growth and value stocks. But during market enthusiasms, the stocks of a particular industry can become so overvalued that they dominate the market.'”