index funds

From the Chicago Tribune

Index funds can have same goals, different results.

By Lisa Singhania
Associated Press

July 8, 2002

Index funds have long been a favorite of financial planners, who tout these investments as a relatively inexpensive way to diversify a portfolio.

That endorsement is generally well-deserved. Funds that mimic indexes such as the Standard & Poor's 500 or the Russell 2000 tend to have lower costs than those run by managers, and in some cases they earn higher returns.

But shareholders should be selective--the number of index funds has grown in recent years and, in a bear market, their returns can vary.

"There are a lot of options out there, and investors need to choose carefully," said Ray Mignone, a financial planner in New York. "In this market, there are certain indexes that I think will do better than others."

As of May, there were 234 index funds, compared with 117 just five years ago, according to Morningstar Inc., a fund and stock data service.

Although the funds initially focused on broad market indexes such as the S&P 500, the menu has expanded to track more specific indexes, such as the Dow Jones Real Estate Index.

In recent years, value stocks have outpaced growth stocks in the broader market, and smaller company stocks have outperformed larger ones. So it is not surprising to see the same trends in index funds.

As of June 21, index funds that track a blend of large-cap stocks, such as those in the S&P 500, had a negative return of 13 percent for the year, according to Morningstar.

By contrast, index funds of small-cap stocks had a negative return of 4.2 percent during the same time.

The difference is even more striking when funds that track value and growth indexes are compared. Small-cap value index funds have had a positive return of 6 percent so far this year, compared with a negative 2.1 percent return in small-cap growth index funds.

Large-cap growth index funds have had a negative return of 27.5 percent, compared with a negative return of 9.2 percent for large-cap value index funds.

One of the best performances has been in index funds that track real estate. Year-to-date, the group has returned 11.7 percent--a reflection of the robust housing market as consumers take advantage of low interest rates and investors look for options outside the stock market.

Analysts say investors might benefit from some investment in specialized indexes, but they caution against putting too much in the sector, or in any one area, for that matter.

Since stocks tend to rise and fall in cycles, small caps, for example, might not be as good a long-term investment as a broader index that tracks a wider swath of big and small companies.

The same is true for sector indexes, such as technology.

Three years ago, investors couldn't get enough of technology. Today, many won't go near the sector.

"Industry-specific index funds tend to carry a higher risk or reward, which means you can make or lose a lot," said Nancy Frank, a financial planner in New York. "So I would not bet the farm on them. I also would not use them as a core holding. And make sure you know something about the area you're investing in."

It is also important to understand that a fund's actual holdings might not directly correspond to the index it tracks. That's because indexes can include hundreds or thousands of stocks and a fund might decide it's not efficient to own many of the holdings. So instead of buying everything, index funds will selectively sample.

The results can affect your return, as can the fees and costs associated with administering and updating the fund. To conform with an index, funds have to periodically adjust their holdings, and the rate of what's called turnover can be significant.

A small-cap index, for example, might have to sell the stock of a company that gets too big for the category--triggering a sale by the fund that tracks the index. Since investors face a potential capital gains tax every time a stock in an index fund is sold, this is something to watch out for.

"Some index funds, particularly those in a specific sector, have turnover of 40 to 50 percent. That can really add up," said Russell Kinnel, director of fund analysis at Morningstar. "You could end up doing worse than the index and even an actively managed fund."