Tuesday, November 17, 1998

Indexing Wont Solve All Your Problems, Just Most

Should you index all your investments?

If you look at the evidence for taking a broad ownership position in major American stocks and bonds, the answer is a resounding "Yes!"

Its a yes answer because of the odds. As an index investor in major American equities or fixed income securities, a long history of performance figures shows that chances are youll do better than 4 out of 5 managed investments. Going for the managed investments just isnt a good bet.

Applying the idea of indexing to all investments, however, could produce some disappointments. In spite of low costs and efficiency, index funds have failed to provide significant performance benefits in some areas.

One example is Vanguard Index Small Cap Stocks Fund. One of the oldest index funds, it has the traditional advantage of index funds, low expenses and low portfolio turnover. In spite of that, its history fails to reveal any great advantage to indexing. Measured over the last ten and fifteen year periods it has performed at the 70th and 77th percentile, respectively. This means that three out of four managed funds did better. While its performance has been better over more recent periods, it has never been in the top quartile.

Index Investing in Small Capitalization Domestic Companies

Source: Morningstar Principia, September 31, 1998 data

Much the same can be said of Vanguard Index Extended Market, a fund that invests in an index of companies smaller than the largest 500. Ditto the two Dimensional Funds Advisors funds that invest in smaller companies. If your investment as a betting proposition, history indicates that youve got better than a 50 percent chance of a higher return with a managed portfolio.

Index Investing in Europe and Asia

Source: Morningstar Principia, September 31, 1998 data

It is much the same with international investing. With the glaring exception of Vanguard Index Europe, which has been in the top 20 percent or better for the last five years, the major index funds have been a disappointment. Viewed as a bet, the index fund appears likely to trail a managed fund three times out of four.

Since there are only 15 index funds that have been in operation for at least 10 years and a mere 5 that have been around for at least 15 years, its probably a bit early to say that indexing doesnt work for small capitalization or international stocks. In addition, its also possible that recent statistics for the major S&P 500 index funds will lead us to expect far too much from index funds.

My personal bet: were going to find that rising fund expenses are partially responsible for the poorer performance of managed funds against the index. Over time, a large capitalization stock index fund will continue to beat 3 out of 4 managed funds. Ditto fixed income funds.

That makes index funds very good bets for where most people keep most of their money: big company USA. Id also bet that small cap and international funds would remain an area where managed funds have a 50/50 chance of beating their respective indices. Thats where research may pay off.

One side message: the expense of managing money will come down. A balanced portfolio that is 60 percent equities (30 percent large domestic, 15 percent small domestic, 15 percent international) and 40 percent fixed income would have 70 percent of its assets in indexed funds. Even an aggressive fund with 100 percent of portfolio in equities would have 50 percent of assets in indexed funds.