‘Mindless’ Index Funds Outsmart Stockpickers Segment Produced Modest Gains In 1994, When Managed Mutual Funds Staggered

The way index mutual funds have been performing lately, you’d think they were being run by some pretty smart stockpickers.

These funds managed to post a modest gain, on average, in 1994, when less than one-fourth of all diversified U.S. stock funds were able to do better than break even.

Now in 1995, in a revived stock market that has climbed to record highs, index funds are again outperforming the competition.

But of course the people who run these funds aren’t “stockpickers” at all. They simply buy and hold portfolios that duplicate the makeup of a stock market index such as Standard & Poor’s 500-stock composite.

Index funds are based on the premise that you can’t outsmart the market, so you might as well join it. They gain an automatic edge on their managed counterparts by saving money on research, transaction costs and other expenses that cut into investors’ return.

The principle has been applied in recent years to a wide variety of indexes that track growth stocks, medium-sized stocks, small stocks, foreign stocks and so on. But funds that model themselves after the S&P 500 remain the kingpins. Lipper Analytical Services lists 42 of these funds, with aggregate assets of better than $20 billion.

It is these S&P 500 funds that have racked up the top performance figures of late. According to Lipper, they gained 0.91 percent last year, including reinvestment of dividends, while Lipper’s general equity funds average dropped 1.68 percent.

In the first quarter of 1995, the S&P 500 funds jumped ahead 9.59 percent, outstripping the 7.16 percent rise of Lipper’s general equity funds average by nearly 2.5 percentage points.

“One need look no farther to see the efficacy of an indexed approach to the market,” declares the Value Line Mutual Fund Survey.

To be fair to indexing’s critics, the S&P 500 funds have benefited lately from some special influences. Last year, most analysts agree, the S&P 500’s showing made the overall market look healthier than it really was, with many smaller stocks suffering.

The blue chips don’t always do so well. In the five years through March 31, for instance, Lipper’s small company growth and mid-cap, or medium-sized, fund averages handily outpaced the S&P 500 funds, posting returns of about 78 percent to the 500 funds’ 48 percent.

So while the S&P 500 funds have made a compelling case for themselves lately, some analysts argue that contrary-minded investors might look elsewhere now.

That could mean shopping among small-company funds, international funds or some other category not dominated by U.S. blue chips.

You can invest in those market sectors using index funds. But Value Line says that the argument for indexing weakens as you move away from big American stocks.

The U.S. blue chips represent “an extremely efficient market,” says Gerry Hill, a Value Line analyst. “Stocks that compose the S&P 500 are covered by analysts from virtually every brokerage house, research firm and investment boutique.

“But small-cap stocks as a group receive a fraction of the attention their larger-cap brethren enjoy. Even more inefficiencies exist in overseas markets.”

Hill concludes: “Indexing the S&P 500 is a fine and proven strategy, and it makes sense to pursue it. But stick with actively managed funds for less efficient markets.”