When 31.7 percent total return of the Standard & Poor's 500 Index topped four-fifths of all equity mutual funds in 1989, many investors decided they could do better by getting into funds that were designed just to match the index, not try to beat it.
As they invested millions of dollars in index funds -- especially Vanguard's 500 Portfolio, the oldest and largest -- in hope of doing as well as "the market," other sponsors, such as Dreyfus and Fidelity, started launched funds to accommodate demand. Some were aimed at institutional investors and required high minimum investments.
Skeptics, and competitors who only offered actively managed equity funds, warned of the downside risk of passive index management: If and when the stock market fell, funds indexed to match the market would fall, too. Shareholders would not be insulated by the defensive tactics they could expect of active managers.
Index fund investors apparently were unimpressed by the warnings. While 1990's market drop, of course, proved the critics correct and led to an increase in redemptions, sales of new shares also rose.
Last year, a strong stock market gave index funds a new boost. As many as half of general equity funds did not match the S&P 500's 30.5 percent total return, even if the average return of all of them exceeded it: 35.6 percent, according to Lipper Analytical Services.
Index funds raked in record sums of new cash, with Vanguard's 500 Portfolio gaining the most. Net sales of shares accounted for two-thirds of the increase as its net assets doubled to $4.4 billion.
Given the method for running the portfolio and the liquid markets for its stocks, portfolio manager George U. Sauter said, "It could easily go to $100 billion."
By now, Lipper tracks more than 50 index funds. Only 15 of them are linked to the S&P 500. The rest target other indexes measuring performance of other universes of stocks: large, medium and small companies; precious metals, gas, regional and foreign.
This month, Vanguard introduced a fund whose performance would reflect nothing less than that of the entire U.S. stock market. Called the Total Stock Market Portfolio, it will aim to replicate the investment performance of the Wilshire 5000 Index which, despite its name, is based on the prices of 5,913 stocks. Using a complicated sampling technique, it'll only invest in 1,400 to 1,500 stocks.
Created in 1974, the Wilshire 5000 is regarded by some as the most meaningful measure of the U.S. stock market because of its coverage. The older S&P 500 long has been used as a barometer of the U.S. market and as a benchmark for judging portfolio managers' performance, but its 500 stocks account for only 75 per cent of the market value of U.S. stocks.
Using an index fund for part of your equity fund portfolio can make a lot of sense. Depending on the index to which it's linked, you have a reasonably good idea of how the fund is likely to behave.
A well-run index fund's performance will come close to the index but won't equal it for at least two reasons: funds incur annual expenses and transaction costs, which unmanaged indexes don't; funds may have a small percentage of their assets in lower-yielding cash to take care of redemptions while stock indexes reflect only stocks.
Choosing a fund with the lowest expenses, you'll be more likely to approximate the index. But which index do you want to match?
The table, showing the total returns of four major stock indexes for the last decade, should help.
In reflecting all U.S. stocks, the Wilshire 5000 ranges from Exxon with a market capitalization -- number of shares times share price -- of $71 billion to USR Industries with a cap of only $62,000.
The S&P 500 is primarily an index of large companies. The 500th company, Monarch Machine Tool, has a market cap of $46 million, which is fairly small by today's standards.
The Wilshire 4500 includes all U.S. stocks not in the S&P 500. Thought of as an index of medium and small companies, it is led by Microsoft with a $22 billion market cap.
The Russell 2000 is perhaps the most widely used index of small company stocks. Its average market cap is around $200 million.
Comparing their performance, you can see that the S&P 500 outperformed the others during the last decade, when stocks of large companies excelled.
The Wilshire 5000 came close, reflecting its heavy weighting of large companies. As you would expect, it led the S&P 500 in years when the stocks of small companies were stronger.
If you believe that 1991 ushered in a new period of market leadership by small company stocks, you may prefer a fund linked to a small company index, such as the Russell 2000.
If you prefer large-cap stocks, which usually yield more and are less volatile, you'd want a fund linked to the S&P 500.
For a stake in both camps, consider the new Vanguard fund.
Whatever your choice, remember that the value of any index fund shares you own will drop when the stocks constituting the index fall.