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1. The S&P 500 Index Fund
Many stock investors turn to the letters Warren Buffett, CEO of Berkshire Hathaway (NYSE: BRK.A and B), writes every year to Berkshire's shareholders for some of the most valuable stock investing lessons available anywhere. But mutual fund investors have their own Buffet in John Bogle of the Vanguard Group, whose Common Sense on Mutual Funds contains a distillation of facts, figures, and analysis on mutual funds and are the most comprehensive and useful education that a mutual fund investor can acquire. Investors are certainly indebted to John Bogle, for showing clearly that -- contrary to what you may have read on countless magazine covers -- mutual fund investing is extremely simple: Buy an index fund.
(Psst. There's a reason that all these magazines don't tell you how simple mutual fund investing really is. Scientific marketing surveys and focus group testing have determined that magazines with covers that read "Index Funds: Still The Best Choice!!!" every single month really wouldn't sell as well as magazines that promise "Our BRAND NEW 10 Best Mutual Funds To Buy RIGHT NOW!" Sad, but true.)
In 1975, John Bogle presented an idea to the board of directors of the newly formed Vanguard Group -- create an extremely low-cost mutual fund that would not attempt to beat the returns of the stock market as measured by Standard & Poor's 500 index; instead, it would attempt to mirror the index as closely as it could by buying each of the index's 500 stocks in amounts equal to the weightings within the index itself.
In his presentation to the Vanguard board, Bogle presented the historical data then available to him. In his account of The First Index Fund, Bogle writes:
"I projected the costs of managing an index fund to be 0.3% per year in operating expenses and 0.2% per year in transaction costs. Since fund annual costs at that time appeared to be about 2.0%, I concluded that an index fund should reasonably be expected to provide an annual return of +1.5% above a managed fund."
In the intervening years Bogle has proven to be even more correct about indexing than he had predicted he might be. Since then, the gap between the performance of the market and the performance of actively managed mutual funds taken as a whole has actually been significantly wider than the 1.5% theorized by Bogle in 1976. During the 1990s, the total shortfall between actively managed mutual funds and the market as measured by the S&P 500 has so far been a whopping 3.4% per year.
The differential between actively managed funds and passively managed index funds is very easily explicable. The difference does not come from the actively managed mutual funds being run by buffoons. Not at all. The stocks that mutual fund managers pick end up being more or less average performing stocks. Bogle analyzes the differential as being determined by four factors: costs, turnover, sector, and cash reserves.
During the 1990s, the S&P 500 has provided an annualized return of 17.3%, compared with just 13.9% for the average diversified mutual fund. This 3.4% is explained first by understanding the fact that during the 1990s the S&P 500 (essentially an index of the 500 largest companies in America) has produced returns that are better than the rest of the market. One must first look at an index of the whole stock market, the Wilshire 5000 Index. The return for the Wilshire 5000 has been 16.3% during the 1990s, so you should count 1.0 percentage points as a "large-cap effect," bringing the gap between managed funds and the Wilshire 5000 down to 2.4%.
The expense ratio of the average fund, that is the average amount of expenses that a fund charges its shareholders every year, was about 1.3% during the period. (Over the last couple of years expense ratios have been rising further and currently stand at 1.5%.) By comparison, the Vanguard S&P 500 expense ratio is 0.19%.
Many funds also buy and sell their holdings at a rapid pace. Currently this turnover occurs at an average rate of 85% per year. This means that at the end of every year the average mutual fund only owns 15% of the same shares with which it started the year. The transaction costs involved in buying and selling so many shares every year result in an additional 0.7% of return disappearing every year.
Additionally, fund managers, believing that they can time the market, hold an average of about 8% of their portfolios in cash reserves. This practice has been a very expensive penalty during the bull market of the 1990s. This holding of cash reserves essentially explains the rest of the differential between mutual funds and the market.
Did you get all that? We sure hope so. We'll return and explain all of these concepts in further detail in Part 7 and 8, but if you are invested in any mutual fund and are not currently aware of how expense ratios, turnover, market sector, and cash reserves apply to your fund, you are investing blind.
S&P index funds have garnered a lot of attention over the last couple of years for good reason. The Vanguard S&P 500 fund has outperformed over 90% of all domestic equity mutual funds over the past three and five years (and a much higher number if you include bond and international equity funds). But S&P index funds certainly aren't the only index funds -- and in fact may not even be the best.
2. Beyond The S&P 500 Index Fund
Few years ago, before indexing was cool, and indexing was the way to go with mutual funds. For the most part, during that time the investment community has limited its discussion to the S&P 500 index funds, but it's high time to expand the whole definition of index funds just a little bit.
When you hear, "The market was up 28% in 1998," that means that a particular measurement of the market, in this case the Standard & Poor's 500 Index, was up 28% for the year. Anyone who owned an index fund tracking the S&P 500 during 1998 would also have seen their money grow by basically the same amount. Meanwhile, owners of any of the 88% of actively managed mutual funds that underperformed the S&P would have watched their investment fall short of this benchmark.
But do all index funds just track the S&P 500? Oh no -- if you can name a measurement or index of the market, then somebody probably has an index fund for it. The Russell 2000 (an index of 2000 smaller company stocks), the Wilshire 5000 (the entire stock market -- in reality there are about 9000 publicly traded companies but "the Wilshire 8934" just wouldn't sound too good), the Dow Jones Industrial Average ... just to name a couple of the big ones that we talk about in more detail in our Index Center. The list of different indices that are tracked by mutual funds is getting longer all the time.
And we like them all. Almost.
Different indices will produce different results over the short term, but various ivory tower academic studies show that different sectors of the market have more or less produced the same results over longer periods of time. For example, in 1998 the S&P 500, which indexes the largest companies in America, returned 28%, the S&P MidCap 400 (which tracks medium-sized companies) returned 9% less. However, over the last 10 years, the S&P 500 has returned 19.20% annually, and the S&P MidCap 400 has returned 19.28%. Pretty darn close.
Often it takes longer for the averages to even out like that. The Russell 2000, the best-known small company (or "small cap") index, has returned an average of 12.92% over the last 10 years. Does that mean small caps can't keep up with the bigger companies, or that a small cap index fund should be avoided? Not if you look at the longer term. Over the last 40 or 60 years, the returns of the biggest and smallest companies are nearly identical.
But watch carefully what some companies are selling as "index funds." The real point of investing in index funds is not to try to pick the "hot" index, or to pick the "cold" index before it gets hot. Putting your money into an index fund -- any index fund -- delivers great results to the long-term shareholder mainly because index funds keep costs so low. The Vanguard index funds have annual costs of roughly 0.19%. Full-price brokerage Morgan Stanley, on the other hand, runs an S&P 500 index fund (buying the exact same stocks as Vanguard's fund) with annual costs of 1.5% -- nearly eight times as much!
3. The Index Fund Anatomy Lesson
The S&P 500 Index fund has become the bugaboo of money managers throughout the world by producing excellent pre-tax returns and almost unparalleled after-tax returns. Although many have written of the inability of money managers to beat this benchmark, the systematic analysis of why this is the case has been lackluster. Perhaps it is this more than anything else that allows tabloid financial journalists to periodically craft fear-mongering stories about an S&P mania, despite the fact that only about 8% of all money invested is indexed.
The Standard & Poor's 500 is an index consisting of 500 large companies with sizable U.S. operations that is maintained by the editorial staff of Standard & Poor's, a subsidiary of McGraw Hill. Although there is no set scientific formula for how companies enter and leave the index, the editors are sensitive to including companies representative of the economy at large and tend to pull out companies in the midst of long-term decline. Although the benchmark has existed since the 1923 in some way, shape, or form, its true rise to prominence only began in the late 1980s with the explosion of the mutual fund marketing machine.
By establishing the S&P 500 Index as the de facto standard for comparing mutual fund returns, the industry ironically set itself up for embarrassing performance thereafter. It has been this embarrassing performance that has driven awareness about the S&P 500 Index funds to the masses, where institutions had been hearing that message for almost 20 years. The original academic work on index investing called it "passive" investing and determined that it was the only logical response to what was termed the Efficient Market Theory (EMT). Because academics could find no predictive factors that explained market outperformance, they reasoned that the best thing investors could do was purchase the "market."
Part of the underlying work in EMT was the discovery that money management ability, like just about any other intellectual pursuit, is distributed along the bell curve. While the distribution of performance was not perfect, most money managers appeared to cluster around the mean while there were much fewer who occupied the extremes at either end in any given year. What has not really been remarked on is why this average mutual fund performance is systematically below that available in an S&P Index fund. While some have speculated that the S&P 500 is really not representative of the market as a whole and not a good benchmark, a more subtle, but powerful reason exists that reinforces one of the basic rules for generating excess returns -- don't spend a lot of money.
By definition, a mutual fund's return is the total return of the stock minus any fees associated with investing the money. Because index funds are managed almost on autopilot, fees for these vehicles are extraordinarily low. On the flip side, managed equity funds routinely have expense ratios of 1.0% or higher, meaning that to match the market after the expenses, the fund actually has to beat the market before expenses. To beat the market clearly and decisively, the pre-expense performance has to be extraordinary. In fact, if you imagine a bell curve measuring returns that has been shifted to the left of the pre-expense mean by a percent or two to account for fees, you can easily see why, by definition, the majority of mutual funds have to underperform the benchmark.
Beyond buying an index fund, the reality of this for your portfolio is quite simple. Index funds generate market performance by keeping expenses low. In their rush to put money into the market, individual investors often run up miscellaneous expenses for trades, investment information, and software that costs them quite a bit more of their total capital than one to two percent. For each dollar you pay to invest, you have to make back that dollar plus some more in order to make any money at all. In order to beat index performance where expenses have been minimized through a pattern of long-term holding, you have to be exceptional. Although there are a few individuals that are exceptional, the majority of people are best served by concentrating on how much they spend to invest or they risk underperforming on a pre-tax basis with the same regularity as professional money managers.
3. Spiders: The Index Fund Alternative
The newfangled S&P Depositary Receipts (SPDRs) have been quite popular recently -- particularly among managers of the Fool Portfolio, who purchased some of these arachnids back on December 31, 1997. Because of the flood of questions, it seems like a good idea to go over what may be a superior alternative to an S&P 500 Index fund for many investors.
S&P Depositary Receipts, otherwise known as "spiders," represent a single unit of ownership in the SPDR trust. Units of the trust are bought and sold like individual shares of stock and they trade on the American Stock Exchange under the ticker symbol SPY. As the SPDR trust is a pool of money managed to perfectly mimic the Standard & Poor's 500 Composite Stock Price Index, the price of a unit in the trust is always the current value of the S&P 500 divided by 10.
The SPDR trust is a unit investment trust that operates under different regulations than a traditional mutual fund, meaning that there are some significant differences between the two. One of the main differences between a trust and a mutual fund is that a trust does not have to distribute capital gains. In fact, because shares in the trust are set at the time it is sold, owning a unit in a trust is much more like owning a share of stock than owning a share in a mutual fund. Much like a closed-end mutual fund, when unit trusts come up for sale there are a fixed number of shares outstanding. Investors buy these shares and then trade them among themselves.
State Street Bank & Trust of Boston is the bank that holds the actual stock in trust that is represented by the units that individual investors own. The bank is the entity that deducts the management fee and distributes dividends every three months. SPDRs can be bought and sold throughout the day as they trade freely on the American Stock Exchange, which is for some investors an improvement over S&P 500 Index funds, which can only be bought or sold at the end of a trading day. Also, buying and selling among individual investors in SPDRs does not cause tax consequences for other investors, unlike a mutual fund. In a index fund if there were mass selling that caused the fund to liquidate part of its portfolio, it would cause tax consequences for investors that would be distributed at year end -- the same is not true for SPDRs. Finally, for investors of a perverse bent, you can even short SPDRs, which you cannot do with an index fund.
While it is theoretically possible that one investor could try to corner the market in SPDRs and subsequently drive the price up above the underlying economic value of the S&P 500 companies' shares the unit represents, this is unlikely simply because it would be completely irrational. Because this is theoretically possible, however, the wording the American Stock Exchange uses to describe the SPDRs stresses that it is "reasonable" to expect the market value of SPDRs to conform to the market value of the S&P 500 Index. Although there has been no exhaustive study of the subject done at Fool HQ, it would also be reasonable to expect occasional divergences between the S&P 500 Index and the value of SPDRs, even if they were only a few pennies.
For many investors, SPDRs may be a cheaper than buying an S&P 500 Index fund. The cost of running the SPDR is 0.1845%, versus 0.30% to 0.50% for many S&P 500 Index funds. However, you also need to pay a commission to buy and sell SPDRs that you would need to add to the 0.1845% on a percentage basis to determine whether or not it is really cheaper. The drawback of SPDRs is that, unlike a mutual fund, you cannot put small amounts of money into SPDRs after you open an account without paying a commission. For those investors who regularly put $50 or $100 a month into a S&P 500 Index fund, SPDRs do not make much sense. Take your time, find out how much it will really cost to invest in each alternative by adding commissions to whatever annual expenses would be incurred, determine whether you want to add amounts regularly, and then decide between an S&P Index fund or SPDRs.
5. Construction of an Index Fund
The Nasdaq 100 has significantly outperformed the S&P 500 over the past ten years, yet more money was flowing into S&P 500 index mutual funds. From the end of 1988 to September 30, 1998, the Nasdaq 100 outperformed the S&P 500 by almost 6 percentage points annually, based on returns of 23.1% and 17.3%, respectively. Why, this reader wondered, would investors be funneling more dollars into the fund with lower performance?
There are several reasons for this phenomenon, but his question elicited an important investing point. There are many indices beyond the S&P 500. While the S&P 500 can be the bedrock of most portfolios, those wishing to devote more time to investing but not interested in individual stocks may find other indices that provide higher returns.
Before venturing into index funds, it is helpful to understand the differences in how stocks are selected for inclusion in the indices and how the indices are calculated. Anyone can create an index to track the overall stock market or specific sectors within the market. Some consist of a large number of stocks, while others are quite limited. Perhaps the best known index is the Dow Jones Industrial Average (DJIA) , which is composed of 30 major stocks in various industries picked by the editors at Dow Jones as bellwethers of the U.S. stock market.
The broadest-based index of large companies is the S&P 500. The 500 stocks in the index are selected by Standard and Poor's, based on the company's representation of the U.S. economy, stable financial profile, and liquidity (i.e., high level of trading activity). One of the best performing major indices in recent years is the Nasdaq 100, which tracks the performance of the largest stocks traded on the Nasdaq stock exchange. Inclusion in this index is based on a formula that selects those stocks with the greatest market capitalization (shares outstanding * price per share).
When calculating indices, companies must decide how each stock in it will be weighted. The most popular methodology is based on market capitalization. In an index such as the S&P 500, a stock's weighting is based on the percentage of value of the entire index an individual company comprises. If the market capitalization of a company's stock is $1,000,000 and the market capitalization of all stocks in the index is $20,000,000, the stock would be included as 5% of the index.
The DJIA uses a different methodology -- priced-based weighting. Not surprisingly, this means that the weighting of each individual stock is based on that stock's price relative to the sum of all the stock prices. Assuming that the sum of each stock in a price-based index is $500, a stock trading for $20 would comprise 4% of an index. An unusual impact of such a system is that a stock split has a noticeable effect on a price-based index. If the $20 stock mentioned above declares a 2-for-1 split, ceteris paribus, its weighting would fall to slightly over 2% despite no fundamental change in the companies in the index. For this reason, there aren't too many price-based indices.
The Nasdaq 100 index just switched on December 21 from being a pure market-capitalization based index to a modified market capitalization index. This change will limit the weighting of securities that comprise over 4.5% of the portfolio to increase the portfolio's diversification. This change was implemented because the largest five stocks in the index totaled about 61% of its value. Under the adjustment mechanism, the weighting of these five stocks will be lowered to 40%.
Why should the S&P 500 be the backbone of an indexing strategy? It consists of 500 of the largest U.S. companies across a wide spectrum of industries. The folks at Standard and Poor's who select stocks for the index go out of their way to ensure that the index substantially represents the U.S. economy. Included in this index are car makers, technology companies, pharmaceutical companies, retailers, financial companies, and Internet companies (starting Monday when America Online (NYSE: AOL) joins the index). With such broad diversification across the U.S. economy, the growth in profitability within companies in the index should roughly mirror the overall growth of corporate America's profitability.
The Nasdaq 100, on the other hand, does not have the breadth of the S&P 500. Five stocks, all of them in technology or telecom, make up 40% of the index. In comparison, the S&P 500's top five industries total only 26% of the index. The focus of the Nasdaq 100 is terrific for investors when the included stocks are doing well, but it does not necessarily allow for participation in the overall growth of U.S. corporate profitability. Investing in the Nasdaq 100 is essentially making a bet that the stocks of some large technology and telecom companies are going to outperform the overall market.
There is nothing wrong with having such an investment strategy, but it is quite different from investing in the S&P 500 and the growth in a diverse group of large capitalization U.S. stocks. Before investing in an index such as the Nasdaq 100, you should feel confident about the prospects for the specific sectors that are overweighted in the index. You are not making the less restrictive assumption (implicit with investing in the S&P 500) that the value of corporate America is going to increase over time.
Investing in indexed funds is generally more profitable than investing in actively managed funds with similar objectives because of lower expense ratios and reduced stock turnover. An index fund lowers expenses because it doesn't have to pay fund managers to pick stocks. In addition, the lower turnover inherent in most index funds results in reduced trading costs (not to mention a lessened tax bite for taxable investors).
To easily invest in corporate America in one fell swoop, an S&P 500 index fund is probably your best bet. If you want to invest in more specialized sectors, you can certainly beat that index. Before doing so, however, you should be willing to invest the time to learn about how the index is constructed and the prospects for the stocks of the companies or industries that are emphasized.
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