Thursday, March 25, 1999

Q. I have only been actively interested in investing for about a year although I am 50 years old. I have a good mix in my 401k plan at this time, but have some old IRA funds that I moved out of CD's a little over a year ago into Strong Schafer Value ($20,000) and Van Wagoner Emerging Growth ($4,000).

After reading about index funds in last years' Kiplinger's Mutual Fund issue and then seeing a segment on index funds on "Beyond Wall Street" in the last several months, I am very interested in moving some of my money into index funds. While Kiplinger's is very big on Vanguard Index Funds, I have discovered that Strong has an S&P 500 Index fund so plan to move some of the Schafer Value money to the index fund at Strong.

I have two questions.

First, since Kiplinger's is so big on the Vanguard funds, is there any reason why investing in a Vanguard Index fund would be preferable to investing in a similar index fund with another family of funds? And is the fact that the Vanguard price per share is so much higher than the price per share for newer S&P funds of any consequence?

Second, Would there be any source for looking strictly at index funds by index type where I could compare returns, expenses, etc. by fund families?

—D.B., by e-mail

A. Kiplinger's magazine isn't alone in its enthusiasm for index investing. A recent issue of Business Week was devoted to the subject of investing without brokers or managers. You can read regular coverage on passive investing on my website, under "Couch Potato Portfolios." Basically, money managers need to demonstrate that they can earn their keep. Instead, they keep making assertions that don't stand up to the brute facts of long term performance.

From a handful only a few years ago, there are now 229 index funds. Of that number, Morningstar categorizes 107 as "large blend" funds. While not all are indexed to the S&P 500, most are. Morningstar, the Chicago financial data firm, is the best known source for data on mutual funds.

The case for Vanguard is very simple: they are the original index fund firm and they remain an established low cost provider. It is possible, however, to buy an index fund and pay "retail" for it— some have relatively high expense ratios. The Strong Index 500 fund has no expenses at the moment and was established in May 1997 so it can be considered a new guy in the game. Like most fund firms, they are offering it out of competitive necessity. It would be a reasonable choice.

The price per share has no relevance for a purchase. What is relevant is the potential capital gains exposure in your purchase. Because index funds have very little portfolio turnover they are tax efficient and distribute very little in realized capital gains. Unfortunately, that also means that index funds tend to accumulate large unrealized capital gains.

For most investors, most of the time, this does not matter. If your investment is in a tax-deferred account, unrealized capital gains simply don't matter. It is also irrelevant as long as the fund in question is gaining new shareholders and assets. Indeed, the new investors work to dilute the capital gains exposure of earlier shareholders.

Unrealized capital gains could become a problem, however, if you own the fund in a taxable account, the market turns down, and shareholders leave the fund. Then the fund would need to realize capital gains to meet redemptions and would distribute tax liabilities to shareholders even as the value of the fund declined. Any fund that has been in operation for at least three years has large unrealized capital gains.

Can you make decisions or act on this information? Probably not. It's just good to know and understand.

Q. I have heard many in the news media give Clinton credit for the booming economy. Just how much credit should he be given? Are there other individuals that could be given "credit"?

—E.G., Plano, TX

A. Politicians of all persuasions regularly take credit for positive economic trends and blame their opponents for negative economic trends. When they make a difference, it is usually by changing economic policies. Margaret Thatcher is a good example.

So is Ronald Reagan. It was his decisions about energy and his influence on monetary policy that brought inflation to an end. Twenty years from now I think the history books will show that Mr. Clinton was an insignificant President who benefited from a combination of "dividends" from Reagan policies and a period of major technological change.