Index Funds’ Downside: If The Market Drops, They Get Taken Along For The Ride

A fairly easy way to ride the bull, investors discovered as the market climbed, has been to put their money into index funds. Holding stocks that match those in a benchmark like the Standard & Poor’s 500-stock index, these funds let investors enjoy the same big strides as the market.

But then came last month’s drop. The Vanguard fund lost nearly 7 percent of its value, joining other index funds in an undefended tumble with the overall market. And stunned investors were left asking: Is indexing really the way to go?

A large group of investors are in this quandary. Morningstar Inc. the fund researchers in Chicago, counts 88 index funds that track the S&P 500, up from 5 in 1987. Over all, there are 156 index funds that track everything from bonds to small stocks to overseas stocks, up from just 12 a decade ago, and only 4 in 1983. These funds hold more than $140.6 billion in assets, up from $2.1 billion in 1987.

The market break showed the true nature of index funds.

I hate to say, `I told you so,’ but index funds are designed to give you exact market returns, said Peggy Ruhlin, of Budros & Ruhlin, financial planners and investment advisers in Columbus, Ohio. When the market goes up, you do great, but when the market goes down, you don’t do so well.

Index funds are inherently more vulnerable to corrections in the stock and bond markets than actively managed funds because, to track their indexes as closely as possible, they must be fully invested at all times. That means they hold no cash reserves to provide a cushion during a market rout. (To meet everyday redemptions, the funds will generally liquidate futures positions or draw on credit lines.)

And managers of index funds, unlike managers of actively managed funds, have no discretion in the types of stocks they buy. In a more gradual decline than last month’s, active managers might add some bonds to prop up returns, or retreat into the types of stocks that are more likely to hold up in a bear market.

So while advisers say index funds can be excellent long-term investments, they tend to be very volatile in the short term. As a result, advisers generally warn investors against buying into an index fund if they will need the money in a few years.

So does it make sense to hold onto an investment in index funds?

Three fund experts were unanimous in their advice: If you view an index fund as a better-paying alternative to a bank certificate of deposit, you should reconsider the investment. On the other hand, if you think the advantages of owning an index fund still outweigh the disadvantages, stick with it.

The bottom line is that index funds can be a very efficient, low-maintenance and low-cost way to invest, said Susan Dziubinski, editor of Morningstar Investor, a newsletter. What you see is what you get.

Index funds can offer a host of advantages over actively managed funds. Because they hold no cash, they make the most of overall market gains when the market is climbing. They also boast greater tax efficiency because they use a buy-and-hold strategy that minimizes capital-gains payments to investors. And investors who look carefully can find funds that cut expenses to the bone.

Index funds are also simple—virtually no analysis is required to understand their strategy. And in some asset classes, most notably among bigger stocks, there is a greater probability of picking an index fund that will beat its actively managed counterpart, said Susan Belden, editor of the No-Load Fund Analyst in San Francisco.

The formula is reversed, however, among smaller stocks. In a recent study, Belden compared the performance of three categories of small-stock funds with the Russell 2000 index, a small-stock benchmark, using data for the 5, 10 and 14 years ended in June. The Russell returns were adjusted downward by 0.25 percent, the amount Vanguard charges in its Russell 2000 index fund.

All three fund groups—emerging-growth small caps, small-cap growth-at-a-price and small-cap value—beat the index during all three periods, despite their higher expenses.

Belden concluded that the pricing inefficiency in the small-stock market—that is, the opportunities for stock-picking that arise because many of the companies are not widely followed and therefore information is not widely available—seemed to create enough chances for fund managers to overcome the problems of expenses and cash holdings.

A similar analysis with mid-cap funds led her to conclude that while there have been opportunities for mid-cap managers to beat their index, that window of opportunity seems to be closing as more people focus on the mid-cap market and pricing becomes more efficient.