Stock index mutual funds deviate from the script
The triumphal march of stock index mutual funds has missed a step or two lately.
New competition and less rosy performance comparisons with actively managed funds have put off the coronation in the marketplace long predicted by academics and the financial press.
Indexing, in which pools of money are set up to match a market index rather than trying to beat it, continues to flourish in many ways.
With the natural advantages it enjoys, including lower costs, it probably always will.
But the success story isn't following the script written just a few years ago. Only four of the top 20 best-selling US funds in 2004 were index funds, according to statistics from the consulting firm Financial Research Corp. in Boston.
Just one of those, 10th-ranked Vanguard Total Stock Market Index fund, was a conventional mutual fund. The other three were upstart exchange-traded funds, a corner of the business that indexing has all to itself until ETFs can successfully be adapted to hold actively managed portfolios.
"Most people still try to seek out the best active managers," says Howard Schneider, president of consulting firm Practical Perspectives in Boxford. "Hard as it may be to do that, they try anyway. It's in our culture. We don't aspire to average results, we aspire to be above average."
The top sellers among ETF index vehicles these days include State Street Corp.'s SPDR Trust and Ishares ETFs offered by Barclays Global Investors that are organized around such specialties as international and dividend-paying stocks.
ETFs can appeal to the same audience as index mutual funds, with some added allure for people who want a vehicle priced continuously by the market throughout the trading day. They had a strong year in 2004, posting an increase in assets of almost 50 percent to $226.2 billion. Even so, the total in ETFs still amounts to less than 3 cents for every dollar invested in conventional US mutual funds.
That's the external competitive pressure. Meanwhile, competition within the conventional fund business threatens to turn old-style index mutuals into a commoditized loss leader.
In recent newspaper and magazine advertising, Fidelity Investments has used a full-page layout to promote "index funds from Fidelity for 10 basis points," or annual expenses of a tenth of a percentage point of assets.
The giant "10!" that headed the ad represented a landmark event in an industry seldom known heretofore for price competition or melees over market share.
In the 1990s, when index mutuals were often hailed as the simple all-purpose answer to just about every investment problem, Vanguard Total Stock Market and its bigger sibling, the Vanguard 500 Index fund, racked up dazzling performance numbers.
In the past five years through the end of January, however, Bloomberg data show Total Stock Market with a 1.1 percent-a-year decline and Vanguard 500 losing 1.9 percent a year, while the average of all stock funds gained 1.8 percent annualized.
One simple explanation for the turnabout in performance comparisons: In the late 1990s, the big stocks that dominate the indexes outperformed the great mass of medium-sized and smaller stocks. Since the turn of the millennium, small stocks have been ascendant.
If big stocks start looking stronger again, so may the results of the broad index funds. That is a possibility many investors have been talking up lately.
"For five years, the average stock in a given index has outperformed that index -- that is, there have been more stocks finishing above the average than below it, thanks in large part to the performance of small caps," said Bob Doll, president of Merrill Lynch Investment Managers in New York. "We believe that valuations and fundamentals will reverse that trend in 2005."
On that basis, Merrill Lynch has lately been promoting its managed funds that specialize in big stocks. The same force, if it indeed materializes, could also give indexers a boost up the charts.
Some of the former fervor for indexing could then be restored. Even in that event, however, the grandest visions have been scaled down a bit, and are likely to stay that way.
Chet Currier is a columnist for Bloomberg News.
