Index Mania! Is the flood of new index funds too much of a good thing?
(MONEY Magazine) – Why is it that when something is working just fine, we get the urge to tinker with it until we muck it up? Take indexing. When it was introduced back in the '70s, indexing was seen as a simple, low-cost strategy for harnessing the power of the stock market. All you had to do was buy a fund based on a broad market index like Standard & Poor's 500, then sit back and enjoy yourself as your fund outperformed most active managers.
But in the past few years, that simple premise has given way to a more complicated one in which broad indexes are sliced into dozens of smaller, more specialized ones: indexes of growth and value stocks, small-, large- and midcap shares, and countless sectors and subsectors. Technology not specialized enough for you? How about an index of semiconductor or broadband stocks? One fund--the Huntington Rotating Index Fund--even shifts its assets from one index to another depending on the manager's economic outlook for the next 12 months.
These days, indexing isn't so much about matching the market as trying to beat it by flitting in and out of indexes the way investors trade hot stocks. "It reminds me of that tune 'Look What They've Done to My Song, Ma,'" says John Bogle, who created the first stock-index mutual fund at Vanguard in 1976. "One line says, 'They've tied it up in a plastic bag and turned it upside down.' That's how I feel about what's going on with my little invention."
Is Bogle right? Has indexing been turned on its head? Or is this a case of grumbling by a pioneer who can't bear to see his Big Idea evolve in ways he didn't foresee? This month, we'll take a look at what's going on in the world of indexing--and consider what individual investors should or shouldn't be doing with the avalanche of new index offerings.
Index this! There's no doubt that indexing has reached almost fad proportions among investors. (See the chart at left.) But it wasn't always that way. When Vanguard introduced its S&P 500 index fund a quarter-century ago, the reception was so tepid that the fund was dubbed "Bogle's folly." Then as the '80s bull market kicked into high gear, the index concept caught on, and Vanguard and other companies began expanding their offerings.
The real revolution began in the early 1990s with the introduction of exchange-traded funds, or ETFs, which can be bought and sold just like stocks. The first ETF, SPDRs (S&P Depositary Receipts), or Spiders as they're better known, began trading on the American Stock Exchange in 1993. Then in 1999 came Qubes--so named because of their QQQ ticker symbol--which are an index of the 100 largest nonfinancial firms trading on Nasdaq. Qubes quickly became a way for investors to jump into the tech craze. Finally, the revolution kicked into overdrive in 2000 when Barclays Global Investors unveiled its iShares, whose unique system of creating and redeeming shares can give them a slight tax advantage over regular index funds. Soon Barclays was pumping out iShares based on indexes of everything from South Korean and Malaysian stocks to chemical, biotech and networking stocks.
And more index choices are on the way. Nasdaq plans to introduce an ETF based on the entire Nasdaq composite index, so you'll be able to buy all 4,000 or so Nasdaq-listed companies in a single trade. Meanwhile, as part of its plan to revamp its well-known style boxes, fund-research firm Morningstar will launch 16 style indexes, which means investors should eventually be able to buy stock funds or ETFs based on Morningstar's criteria for various permutations of size (large-, mid- and small-cap) and style (value, growth or blend). The demand for indexes is so insatiable that I wouldn't be surprised if a dozen funds based on even more arcane indexes have sprouted into existence by the time you read this sentence.
Options galore. No one denies that the sheer breadth of indexes gives investors more choice and flexibility than ever before. Let's say you want your portfolio to reflect the broad market, but you also want to overweight a couple of sectors you think will outperform in the months ahead. Instead of investing in a broad index like the S&P 500 or the Wilshire 5,000, you could create your own mix by buying a group of sector iShares or industry-specific Spiders that reflect your market outlook--stashing more money, say, in financials and cyclicals while underweighting health care and energy.
For that matter, since ETFs can be traded just like stocks, you could leverage your bet on financials by placing a margin order--that is, borrowing money from your broker and investing it in a financial ETF--a technique that would allow you to double up your bet on the sector.
And if you want to get really, really fancy, you can even try trading strategies that until recently were pretty much limited to the pros. Let's say that back in late January 2001, you didn't have much of an opinion either way about how the overall market would fare, but you did believe that, at its then price of about $80 a share, Enron was overvalued and thus likely to fare worse than utilities overall. To exploit this situation, you could have adopted a "market neutral" strategy. Essentially, you would "go long" the entire utilities sector--that is, buy a utilities ETF--and then short Enron shares. This way, regardless of whether the stock market, utilities or Enron went up or down, you would make money--as long as Enron performed worse than the utility sector. And, indeed, someone who made such a bet in early 2001 would have profited handsomely, as Enron shares plummeted 99.7% to as low as 26[cents] a share over the next year while the utilities sector lost just 23%.
Good, bad or ugly? But just because you can trade in and out of indexes this way doesn't mean you should. If you really think you're going to boost your returns by jumping in and out of sectors, I think you're delusional or dangerously overconfident. Back in 1999, for example, investors poured nearly seven times as much money into Vanguard's growth index fund as into its value index--only to see the growth index lose 22.2% the following year, and the value index gain 6.1%.
And remember, no strategy, no matter how sophisticated, can eliminate risk or guarantee profits. Sure, that Enron play I mentioned earlier worked great in hindsight. But in early 2001, before Enron's accounting shenanigans were generally known, Enron was still considered a terrific stock. So you might have been more likely to do the reverse of what I described above--that is, short the utility sector and go long Enron--in which case you would have gotten creamed when Enron imploded.
Stick to basics. Ultimately, I think you'll do better following the Bogle model of index funds--that is, buying and holding a fund that tracks a broad market index. That's not to say I can't imagine any scenario under which mixing and matching different indexes would be appropriate. I could understand a retired investor, for example, tilting his or her portfolio mix slightly toward a value index to dampen volatility. Or if you work, say, for a financial services firm and have much of your 401(k) invested in company stock that you can't move, or your net worth consists largely of company stock options, then I could see buying sector index funds to construct a customized version of the broad market that underweights or, for that matter, eliminates the financial sector of the market.
But given the high rates of turnover in Spiders, Qubes and other ETFs, I suspect that many investors are engaging in the same frenetic trading in indexes that's been going on in stocks for years. In short, they're tying up indexing in a plastic bag and turning it upside down. If you're one of these investors, I suggest you reconsider your strategy. Otherwise, you may soon find yourself crying, "Look what I've done to my portfolio, Ma."