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A new investing landscape?
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March 31, 1999: 3:17 p.m. ET
Analysts debate pros and cons of stock picking, indexing, and value vs. growth
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NEW YORK (CNNfn) - If you rode the bull market on the back of a top-performing S&P 500 index fund, it's time to turn off the autopilot and take a good look around you.
The economy is still motoring onward, and there are few signs of inflation. But just a handful of the largest companies have fueled the market. How much longer can a few big names keep soaring -- and what about the thousands of other companies that missed the ride?
"There are a lot of different ways to invest," said Ken Gregory, president of Litman/Gregory Fund Advisors in Orinda, Calif. "I would just use a different approach than the S&P 500."
Looking beyond the S&P 500
The S&P 500 earned 23 percent to almost 38 percent in the years between 1995 and 1998, and has far outperformed the rest of the market. Growth stocks have led the way, while value stocks were left in the dust.
Charles Crane, chief market strategist at Key Asset Management, said other indexes inevitably will start catching up to the S&P 500, whether it's in 1999 or 2000.
"The days of the S&P 500 outperforming all other indices are limited," Crane said.
He's leaning toward parts of the market that have lagged -- value stocks, and small- to mid-sized companies. Even selected commodities, a sector that has taken a beating, show some promise.
"A lot of professional investors and a lot of retail investors have been selling low and buying high," Crane said. "They've been bailing out of stocks that have performed poorly…I've always been told you make money by buying low and selling high."
Is indexing 'in' or 'out'?
Marty Whitman, chairman of Third Avenue Funds and a well-known value investor, said he sees a two-tiered market. On the one side, bargain stocks haven't been cheaper since 1973.
"The other stocks have gone crazy," said Whitman, who manages the Third Avenue Value Fund.
Whitman thinks it's time for investors to be stock pickers. He's got a team of researchers who do nothing but study companies.
"They study companies, not the markets," Whitman said.
He thinks the leading indexes can't keep going up based on simple math: The growth of the indexes has far outpaced the book value and earnings of the companies so that the market prices are "grossly out of line with corporate reality."
"How long can their luck hold out?" Whitman asked about indexing.
Tell that to an indexer, and he's likely to paraphrase Mark Twain.
"This is the 12th year in a row that [analysts say] it's a tricky market and you have to be a stock picker," said Gus Sauter, managing director at Vanguard Group, a leading index fund family. "For the past 12 years, active managers have consistently underperformed their benchmarks."
In every market, some stocks do well and some don't, he said.
"Last year, it was a stock picker's market if you happened to pick Dell (DELL), America Online (AOL) and Amazon.com (AMZN)," Sauter said.
He said index funds should outperform stock pickers 55 to 60 percent of the time. Over a longer time period, say 5 or 10 years, the number is 75 to 80 percent.
One change, however, is that the indexing universe is getting bigger. Back in the 1970s, S&P 500 index funds were an investor's only option. These days, there are indexes to mirror bond markets, international markets, specific sectors, and big and small companies. There's even the Wilshire 5000 index geared to mirror the entire U.S. market.
"It's a way to gain low-cost, very tax-efficient exposure to the market," Sauter said.
While index funds remain a small portion of the overall fund market, they are getting more attention, Sauter said. In 1997, 14 percent of fund assets were going toward index funds; in 1998, the number was 23 percent.
At Vanguard, more than 50 percent of the cash flow into index funds goes into those that mirror the S&P 500, Sauter said. But there is one difference -- institutional money is flowing out of S&P 500 index funds for other types of index funds and other parts of the market, both domestic and international.
"We don't believe this is any major result of a fear of large cap stocks," Sauter said. "It's the idea you should have broader diversification."
Another argument for indexing is that active managers don't have such a great track record against market benchmarks. According to a review by Morningstar, a Chicago fund-tracker, fewer than 5 percent of actively managed funds beat the S&P 500 between 1993 and 1998.
Shifting market, shifting strategies
But changing times may require new approaches. A recent study by Charles Schwab & Co. found it's better to combine stock picking and indexing in different sectors.
Investors who blend the two investing styles can increase their returns and beat market benchmarks with less risk and volatility, the study said.
The idea is to rely on indexing in parts of the market where active managers have been less successful, said Mark Riepe, head of the Schwab Center for Investment Research. Likewise, Schwab recommends investors use the "active" portion of their portfolios for areas of the market where stock pickers have had success.
That means in this market you'd index large cap stocks, because the odds of a manager beating the market are smaller, Riepe said. But in small cap stocks or an international market, you'd pick a manager who's had success.
Gregory, of Litman/Gregory Fund Advisors, is banking on yet another approach. His company's Masters' Select Funds focus a portfolio on a much smaller number of stocks.
The Masters' Select Equity Fund, for example, has a total of six managers, with four managers responsible for 20 percent of the fund each and two managers in charge of 10 percent each.
Each of the managers picks as few as five but no more than 15 stocks.
"The idea is they can focus on those stocks," Gregory said.
The fund is up 5.08 percent year to date as of Monday, according to Morningstar. It is ranked in the 49th percentile, putting it in the middle of the pack.
But Gregory said that three of the large cap managers outperformed the S&P 500 by 4 percent after fees in the first two years. Two other managers outperformed the Russell 2000 by about 16 percent in the same time.
One manager, Mason Hawkins, even outperformed his own group of funds at Southeastern Asset Management, Gregory said.
Only one of the managers, Jean-Marie Eveillard, whose value funds have struggled, fell short in returns.
"Jean-Marie is a very good stock picker, but he runs diversified portfolios, and we felt he wasn't that comfortable with concentrated portfolios," Gregory said. Masters' Select Funds replaced Eveillard in October 1998 with Robert Sanborn, who has more experience with focused portfolios, Gregory said.
Gregory declined to comment about the holdings, saying the managers don't like to give away their ideas. But according to Morningstar, the fund owns 78 stocks, with top holdings of air freight company FDX Corp. (FDX), Netherlands-based Philips Electronics NV, Texas Instruments (TXN),Seagram (VO) and MCI WorldCom (WCOM).
Overall, Gregory says there is no single answer for investors in 1999. Indexing is a fine alternative for some investors, while stock picking is good for others.
"You can slice it many different ways," Gregory said. "There isn't one right way."
-- by staff writer Martine Costello
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