(April 10) – “Any investors may think that they are protected from stormy markets by investing in a large-stock index fund. They couldn’t be more wrong,” writes Gretchen Morgenson in The Sunday New York Times.
“With the major market indexes lurching to the precipice and back, it is more important than ever that investors understand the limitations of index investing today. Although index funds provide an inexpensive way for investors to mirror the performance of broad market indexes like the Standard & Poor’s 500, the strategy has become increasingly risky in recent years. Because of the way these funds are put together, they are much less diversified than they used to be, making it important for investors to take a more active role in broadening their portfolios.
“‘By dint of their popularity, we can’t ignore indexes,’ said Anthony Maramarco, portfolio manager at the Babson Value fund in Cambridge, Mass. ‘But we also should realise that the widely publicised indexes haven’t for some time delivered on their claim of being a truly representative measure of stock market performance.’
“After years of soaring performance, investing on auto pilot has gone into a stall. Funds that try to reproduce the action of the S.& P. 500, by far the most popular of the index funds, were up only 2.13 percent, on average, in the first quarter. That is a far cry from the gains of 20 percent and more that investors in these funds have grown accustomed to seeing in recent years.
“With returns on index funds so low, it is not that surprising that the flood of money into them has slowed significantly. Lipper Inc. estimates that $2.6 billion went into S.& P. 500 index funds in January, less than half the $6 billion during the corresponding month of 1999. And February saw an even greater falloff in cash flows: just $300 million, compared with $4.4 billion in the month a year earlier.
“Still, these mutual funds remain home to a huge chunk of investor assets. More than $228 billion was in S.& P. 500 index funds as of the end of February, Lipper said. Although investors are putting fresh money elsewhere — mostly into technology stock funds — they still have plenty of their eggs in the index fund basket. As gains in the major indexes have slowed, or reversed, many money managers have been finding the S.& P. 500 an easy benchmark to beat. According to Morningstar Inc., nearly two-thirds of diversified mutual funds investing in United States stocks are outperforming S.& P. 500 index funds this year. That is quite a turnabout. Three years ago, only 11 percent of mutual fund managers beat the index.
“All of this makes it a very good time to reassess the index fund phenomenon. Index funds have much going for them, but they have downsides as well. Perhaps the biggest problem is the idea that an investment in an S.& P. 500 index fund is an investment in the broadly diversified overall market. Because of the way most stock indexes are constructed, funds that mimic them have heavier weightings in some sectors than in others. This makes them much riskier than a more diversified portfolio.”