Q. You and many others recommend Vanguard Index fund. But I heard a financial advisor on TV tell someone not to invest in Vanguard Index because it has no manager and that is like a car without a driver, a ship without a captain. Is this possible?
—R. G., Fort Worth, TX
A. We need to make a trip from the literal to the metaphorical. First, Vanguard has a number of index funds. Each is constructed to duplicate a particular index of common stocks. While the best known is Vanguard Index 500, a fund that duplicates the performance of the Standard and Poors 500 Index, they also have a fund of small stocks, European stocks, and pacific stocks. Second, all of those funds are managed in that a person is in charge. The management job, however, is to maintain the portfolio so that it duplicates its chosen index.
Wells Fargo Bank started the first index fund in the early seventies when a number of studies found that most funds with captains ( or drivers) didnt perform as well as a broad market index. The academic explanation is that funds with captains have higher costs from both management fees and trading expenses and that most managers dont add enough performance from their decisions to overcome the additional costs.
The Vanguard Index 500 fund has annual expenses of 0.20 percent while the average domestic equity fund has annual expenses of 1.42 percent. While that 1.22 percent may not seem like much of an expense advantage, it is a major benefit over a long period of time.
At the end of July, the Vanguard Index 500 fund had provided a better performance than 94 percent of all growth and income funds over the last 15 years. Its worst performance was over the last 5 years when it "only" outperformed 86 percent of all growth and income funds. While an index fund would do better than about 70 percent of its managed competitors in the past, rising fund expenses and the cost of increased portfolio turnover may mean that an inexpensive index fund will beat MORE of its managed competitors in the future, not less.
One major worry about the Vanguard Index 500 fund is that it is capitalization weighted which means that large companies account for most of the money invested in the index. Worse, many of the largest companies are selling at very high multiples of earnings. The most commonly cited is Coca-Cola. If Coca-Cola suffers a large decline, it could mean that the index will underperform managed portfolios for a period of time. Indeed, that could be happening right now given Cokes decline since mid summer.
One way to avoid that, suggested by Bud Lyles, President of the Dallas Chapter of the American Association of Individual Investors, is to switch to the Vanguard Total Stock Market Fund and "own" the entire market. Another way would be to move some money to Vanguard Index Value, an index fund that concentrates on stocks that sell at lower multiples of earnings.
Finally, if you are philosophically inclined, you might consider that buying an "index" of human productive activity isnt such a bad idea. In the aggregate, we create far more than we destroy and do more good than bad. If you were a follower of philosophers Hegel or Teilhard deChardin you would say that the market has a Captain who knows more than any human.
Q. You have mentioned Morningstar Principia software several times. How can I find out about it or order it?
—A. R., Dallas, TX
A. Many readers have asked this question. Morningstar, the Chicago mutual fund data firm, sells a data and software package for Windows based computers. The software has levels of information and capability up to portfolio development and they offer data on open end mutual funds, closed end funds, and variable annuities. You can learn more by calling 312-696-6000. Before spending the money, however, I suggest some web cruising. Internet ready readers can do some testing of mutual fund screening on a number of websites, including Morningstars, . The most sophisticated portfolio planning uses— such as those done by financial planners— require their Portfolio Developer software.
Questions about personal finance and investments may be sent to: Scott Burns, The Dallas Morning News, P.O. Box 655237, Dallas 75265; or faxed to (214)-977-8776; e-mail to firstname.lastname@example.org Check the website: "www.scottburns.com." Questions of general interest will be answered in future columns.