November 6, 2003

Index Funds Beyond the S&P 500

Nov. 4, 2003 -- Standard & Poor's 500-stock index is the giant of the index mutual fund world. More than 160 funds track the broad-based index, including the country's largest mutual fund, Vanguard 500 Index/Inv (VFINX). But, S&P 500 funds aren't alone anymore. Including different share classes, a staggering 583 mutual funds now track indexes. Investors can choose from the major U.S. stock and bond market indexes, indexes that track countries such as Malaysia or the Netherlands, or indexes that cover the gas market. Some juice up their returns with options, offering multiples or the opposite of an index's return. Others finely slice the market according to investment style, such as large-cap, small-cap, value or growth.

Index funds have several advantages: They have low costs, are tax-efficient, and beat active money managers over the long haul. A recent Standard & Poor's study shows that the S&P 500 index beat 53.4% of large-cap funds over the last five years. So why pay active managers all that extra to futilely try to beat the market when you can bet with the market?

With all the index choices out there, how do you find the one that makes sense for your portfolio?

First, let's look at the S&P 500 index. Standard & Poor's picks the companies in the index based not only on size, but also what sectors they are in, so the index represents a wide swath of corporate America. Its holdings are weighted by market capitalization. The top ten holdings account for just a quarter -- 23.6% -- of the index. That means the index is a close proxy for the biggest companies in America.

The problem with that is you don't want to just invest in big companies. For a diversified portfolio, you want all kinds of companies, especially small ones.

Vanguard founder John Bogle, often thought of as the godfather of index funds, recommends investing in funds that track the Wilshire 5000-stock index. The name 5000 is a misnomer as this index covers all companies that regularly trade, a constantly changing pool that currently encompasses some 6,500 companies. Funds that track the Wilshire typically take a sampling of the smaller companies to keep trading costs low.

While the Wilshire index encompasses a wider range of companies, since it is weighted by size, the big companies in the S&P 500 index make up the bulk of the portfolio. For example, in Vanguard Total Stock Market Index/Inv (VTSMX), which tracks the Wilshire index, the top ten holdings make up about 19% of the portfolio. The median size of the companies in the Vanguard fund is $26.2 billion, which is much smaller than the $49 billion median size of holdings in Vanguard 500 Index Fund, but still quite large.

Moreover, indexes that try to cover a broad market end up closely mimicking the S&P 500 index in performance. Over the last decade through September, Vanguard's 500 Index Fund averaged 10.0%, versus 9.4% for Vanguard Total Stock Market Index Fund, a small difference.

"What I hear people say, if you want broad market exposure, is go to the Wilshire. But that index is also cap-weighted," says Rosanne Pane, S&P's chief mutual fund strategist.

Funds that try to beat the S&P 500 by letting a manager try to outsmart the market often end up outwitted themselves and weighed down by heavy fees. Nationwide S&P 500 Index/B (NBSPX), for example, carries a 1.23% expense ratio, a 1% 12b-1 fee, and a 5% back-end load. The fund returned 13.6% so far this year through September.

Three fund families -- Potomac, Rydex, and ProFunds -- offer souped up index funds. You will always find these funds at the bottom and top of performance charts because they promise to multiply, and sometimes reverse, the performance of popular indexes. For example, there's UltraBull ProFund/Inv (ULPIX), which gives investors two times what the S&P 500 does in a given day. Last year, the fund lost than 46.5%. Meanwhile, Bear ProFund/Inv (BRPIX) offers the inverse of the S&P 500's performance and had a pretty good 2002, gaining 20.9%. One problem with these funds is they track daily performance so big losing days are difficult to make up. Say a fund valued at 100 loses 10% one day, then gains 10% the next. The fund price would go from 100 to 90 to 99. A fund that doubled the daily movements would go from 100 to 80 to 88.

These enhanced funds are no substitute for a broad-based index fund like an S&P 500 fund. In fact, they have the opposite philosophy: they are for people who think they know better than everyone else where the market is going. Rydex and ProFunds offer specialized sector index funds and not just garden variety telecom funds, either. There's also ProFunds:UltraDow 30/Inv (UDPIX), which offers twice the daily performance of the Dow Jones Industrial Average, and ProFunds:Basic Materials Ultrasector/Inv (BMPIX), which offers 150%, of the daily performance of the Dow Jones U.S. Basic Materials Sector Index.

The real values for investors looking for diversity outside S&P 500 index funds, however, are found in small-cap and international funds. These funds offer performance that usually diverges from an S&P 500 fund. Most asset allocation models show that investors should have some exposure to small-cap and international stocks, which many believe have a stronger potential for growth than big, established stocks.

We looked for international funds that did not follow a single country, had at least a three-star ranking, no front-end sales charges, and expenses of less than 1%. The results: 11 funds open to retail investors. In the last three years, they each lost around 9% - 10%, and in the last year, they gained about 25%. Almost all of these follow some variation of the Morgan Stanley Capital International (MSCI) Europe, Australasia, and Far East (EAFE) index. The exception is Schwab International Index Fd/Inv (SWINX), which follows a Schwab international index.

Investors will have a harder time choosing among small-cap funds. Small-cap index funds offer a much wider selection of indexes to invest in.

The standard is the Russell 2000-stock index, which takes out the 1,000 biggest companies and then tracks the remaining 2,000. Twenty funds are based on that index, which was up 28.6% this year through the third quarter. Another 30 follow S&P's SmallCap 600-stock index, which was up 20.9% for the same period.

We looked at small-cap index funds with a four-star ranking. Dreyfus Small Cap Stock Index (DISSX) was the only fund open to retail investors that made the grade. The fund, which returned 20.2% this year through September, tracks the S&P SmallCap 600 Index. The index currently includes companies with market capitalizations ranging from $64 million to $3.5 billion. In theory, companies in the index can range in size from $250 million to $900 million.

Typically, the beginning of a bull market is led by small companies, and a mature market is led by big companies, says Jeffrey Hirsch, president of the Hirsch Organization, and editor-in-chief of the Stock Traders Almanac.

"Small caps historically outperform the market," Hirsch says. "They are more volatile, but nothing good ever came in this world that wasn't fueled by speculation."

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