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Understanding Indexing as an Investment Strategy

By Ali Jaffery

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Index investing was once available only to institutional investors, such as pension fund managers. In 1976, Vanguard introduced the first indexed mutual fund available to individual investors: the 500 Index Fund. Since then, index investing has become an increasingly popular investment strategy, with more than $347 billion invested in index funds nationwide, according to Lipper Inc.

In this article, I will explain how indexing has proven to be a simple and powerful approach to long-term investing. I will also offer a few cautionary notes or "caveats."

What Is Indexing?

Indexing is an investment approach that seeks to match the investment returns of a specified stock or bond market benchmark, or index. When indexing, an investment manager attempts to replicate the investment results of the target index by holding all-or in the case of very large indexes, a representative sample-of the securities in the index. There is no attempt to use traditional "active" money management or to make "bets" on individual stocks or narrow industry sectors in an attempt to outpace the index. Thus, indexing is a "passive" investment approach emphasizing broad diversification and low portfolio trading activity.

Indexing's Important Cost Advantage

Although indexing derives from the theory that the markets operate efficiently, its intellectual foundation is based on a simple truth: It is impossible for all stock investors together to outperform the overall stock market.

To understand this point, think of the returns of the stock market as a "pie" to be divided among all investors. Since 1926, the stock market has provided investors with an average return of 11.3% per year. Some investors, because of luck or skill, have earned more than 11.3%, while others have not fared as well. Yet the 11.3% historical average return is, by definition, the entire "pie" that investors are able to divide.

That figure, however, is the gross pie, before costs. Thus, as suggested in Figure 1, investors who gain their fair share of the pie and pay typical costs for investing in conventional stock mutual funds may expect to have a net return reduced by these costs and, therefore, earn significantly less than the market return.

These costs come in the form of:

· The fund's expense ratio (including advisory fees, distribution charges, and operating expenses).

· Transaction costs (brokerage and other trading costs).

Figure 1


The average general equity fund has an annual expense ratio of 1.44% of investor assets. In addition, traditional mutual fund managers have high portfolio activity; the average fund's portfolio turnover rate is 92% per year. (All mutual fund data provided by Lipper Inc.) The trading costs of this portfolio turnover may be expected to subtract an additional 0.5% to 1% annually.

Fund expenses and transaction costs for the typical fund take a hefty bite out of the pie-perhaps by approximately one-fifth of the gross return. Funds charging sales commissions swallow even more of the returns.

By contrast, one of the key advantages of an index fund should be its low cost. An index fund should pay only minimal advisory fees, keep operating expenses at the lowest possible level, and keep portfolio transaction costs at minimal levels. So, the magic of the index fund is that it leaves a larger share of the pie for investors.

The Evidence Speaks for Itself

Actual results confirm the pie analogy. Over time, the broad stock market indexes have outperformed the average general equity fund. Table 1 shows the total return (capital change plus income) of the Wilshire 5000® Total Market Index (a measure of the total U.S. stock market) versus equity funds.

Table 1
Total Return (Ten Years Ended December 31, 1999)

Cumulative Rate (%)

Annual Rate (%)

Wilshire 5000 Total Market Index*

374.09

16.84

Average General Equity Fund

317.76

15.37

*The returns of the index have been reduced by 0.77% per year to reflect approximate index fund costs.

So, experience verifies that index funds have provided very competitive net investment performance over the long term (although past performance is no guarantee of future returns).

Caveat 1

Part of the index stock fund advantage has resulted from being 100% invested in stocks at all times. Since most equity funds maintain cash reserves of 1% to 5% of net assets, they lost ground to index funds as stock prices surged during the 1980s and 1990s. In periods of market declines, index funds, of course, can be expected to have somewhat larger declines than funds that maintain cash reserves.

Indexing as a Long-Term Strategy

Indexing should not be thought of as a "hot" or short-term investment strategy. Indexing gains its advantage over the long term. Figure 2 shows the percentage of equity mutual funds outperformed by the Wilshire 5000 Total Market Index in each year since 1990. In 8 out of 10 years, more than half the funds underperformed the index. But in only two years did the index outperform more than 75% of the funds. Taking a long-term perspective, the index-through its broad diversification and the year-by-year buildup of the cost advantage-surpassed 65% of general equity funds over the 10-year period.

Figure 2

*The returns of the index have been reduced by 0.77% per year to reflect approximate index fund costs.

Indexing's main appeal, then, is not to investors who expect to make a "killing." Instead, the strategy should attract long-term investors who seek a very competitive long-term investment return through broadly diversified portfolios. Such investors find in indexing a high degree of relative predictability-meaning that index funds closely parallel the ups and downs of their respective indexes. Nothing ensures absolute returns, of course, but index investors can feel confident that their investment should not be a dramatic underperformer relative to other funds investing in the same type of securities in any year. Therefore, over the long term, index funds should provide very competitive relative performance.

Because they are designed to provide returns that closely track returns on their benchmark indexes, index funds carry all the risks normally associated with the type of asset the fund holds. So, when the overall stock market falls, you can expect the price of shares in a stock index fund to fall too. Likewise, the share price of a bond index fund will-like the price of individual bonds-fall when interest rates rise. In short, an index fund does not mitigate market risk-the chance that the overall market for bonds or stocks will decline. Indexing merely ensures that your returns will not stray far from the returns on the index that the fund mimics.

Caveat 2

Of course, there will always be actively managed funds that outpace index funds over long periods. It may just be luck-pure chance would say that some investment managers will provide exceptional returns over lengthy "winning streaks." Or it may be skill-there may be some investment managers with truly outstanding abilities who can earn superior returns over time. The problem in selecting actively managed funds is, naturally, identifying in advance those that will be consistently superior over time.

A Variety of Index Offerings

As the number of index funds grows, investors can implement a wide range of distinctive investment strategies. Through indexing, money can be efficiently invested in large, medium, or small companies; "value" or "growth" stocks; international stocks; and fixed-income investments-in combinations suited to an investor's objectives, risk tolerance, and time horizon. Here's a look at some of the indexes that an investor can track.

Blue Chips and Beyond

One of the best-known equity indexes is the Standard & Poor's® 500 Index. Dominated by stocks of large-capitalization "blue chip" companies, the S&P 500 Index accounts for roughly three-fourths of all U.S. stock market value. It provides a solid foundation for investing in U.S. stocks.

Yet the S&P 500 Index excludes the remaining one-quarter of the U.S. stock market represented by small- and medium-sized companies. Investors seeking the broadest diversification can move beyond the S&P 500 Index to the entire U.S. stock market as represented by the Wilshire 5000 Total Market Index, an index of all regularly traded U.S. common stocks. The Wilshire 4500(tm) Completion Index, a subset of the Wilshire 5000 Total Market Index, excludes the stocks in the S&P 500 Index. (See Figure 3.)

Figure 3

Source: Morgan Stanley® Capital International.
The S&P 500 Index is made up of both value and growth stocks. But equity investors who have more specialized objectives, such as emphasizing dividend yields or capital appreciation, may wish to invest in a subset of the S&P 500 Index. Indexes such as the Standard & Poor's 500/BARRA Value Index and the Standard & Poor's 500/BARRA Growth Index, created by Standard & Poor's Corporation and BARRA Associates, enable investors to combine the benefits of either "value" or "growth" equity investing with those of indexing. Please note that investing in two funds-one that tracks the S&P 500/BARRA Value Index and one that tracks the S&P 500/BARRA Growth Index-in roughly equal amounts will achieve a combined total return that approximates that of investing solely in Vanguard® 500 Index Fund.

For investors seeking to invest in small-capitalization stocks, while at the same time using an indexing strategy to minimize the relatively high costs of trading in this area of the stock market, the Russell 2000® Index is the most widely accepted benchmark.

International Indexing

Among U.S. investors in the major international markets, the dominant standard is the Morgan Stanley Capital International Europe, Australasia, Far East (MSCI EAFE®) Index.

In the often-volatile "emerging markets," indexing is a relatively reliable way for investors to reduce the impact of dramatic price swings in any one particular market and to reduce the impact of the high trading costs in these markets. The Morgan Stanley Capital International Select Emerging Markets Free Index consists of stocks in 15 countries-Argentina, Brazil, the Czech Republic, Greece, Hong Kong, Hungary, Indonesia, Israel, Mexico, the Philippines, Poland, Singapore, South Africa, Thailand, and Turkey.

Bond Indexing

Although most of our discussion has been about equity indexing, a strong case can be made for indexed bond investments. The unmanaged Lehman Brothers® Aggregate Bond Index, for example, represents the entire U.S. taxable bond market, encompassing U.S. Treasury and government agency securities, mortgage-backed obligations, and high- and medium-quality corporate bonds. This index can be tracked in its entirety, or an index fund can follow specific maturity sectors, such as short-term, intermediate-term, or long-term.

Indexing Works for Many Types of Investing

As noted earlier, indexing is a long-term strategy. The low costs associated with indexing can provide a powerful long-term edge in many types of investments, as indicated in Figure 4, which shows the percentage of funds in various categories that were outperformed by their respective indexes.

Figure 4
indexfig4.gif (7400 bytes)

*Five years, 1995-1999.
The returns of each index have been reduced by 0.77%, 0.97%, 0.59%, and 0.43% per year, respectively, to reflect approximate index fund costs.
Caveat 3

Indexing is a strategy that has been applied to many different categories of investing. It provides an efficient way for investors to participate in broadly diversified portfolios. Nonetheless, many investors will continue to be attracted to the distinctive investment philosophies and strategies offered by the wide range of actively managed funds. A suitable compromise may be to build equity and bond portfolios (or even combine them through a balanced approach) with a "core" holding in an appropriate index fund. Around that core investment, an investor may select specific actively managed funds that appear likely, in the investor's judgment, to add incremental investment performance over the long run.
Conclusion
Indexing is a time-tested strategy with a variety of applications. And, as the concept becomes more broadly understood by individual investors, an even wider array of index mutual funds will undoubtedly be available to allow for investments in this efficient, diversified manner.
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