Millie the cat's portfolio proves need for care with index funds

Your Funds

Dollars & Sense

November 07, 1999|By Charles Jaffe

IN THE LATE 1980s, I let my cat pick a stock portfolio.

She stretched out almost daily on the stock tables, so I charted for a month the points of her feet and nose. The result was the Millie Index, a column experiment that gained 44 percent and crushed the stock market over the next 12 months.

Were Millie alive today, she would probably have her own mutual fund. What's worse, people would buy such a nonsense fund expressly because it is tied to an index.

Because any dumb idea can be spawned into an index fund, investors must remember that not all indexes are created equal.

That lesson came into focus Monday, when editors at the Wall Street Journal changed the Dow Jones Industrial Average, replacing four stocks in a move that will alter the performance of the benchmark index.

That change serves as a reminder that real people are behind every index. An investment in an index fund is a bet that those strategists have a clue (and aren't relying on a cat).

A well-designed index -- any of the major ones you know by name -- is a group of stocks that makes for a representative sample of "the market" or a sector of the market.

An index fund mirrors the index basket of stocks, providing market-like returns without high management fees.

Jack Bogle, founder of the Vanguard Group and patron saint of index investing, sums up the strategy this way: "Buy every business in America and hold it, at low costs, forever."

The last few years have seen an index mania, and for good reason. Index funds are a cost- and tax-efficient means to capture market returns and generally have outperformed active stock pickers. Those numbers, coupled with the cost and tax advantages of indexing, have attracted scores of investors.

But in the fund business (unofficial motto: "If you can't beat them, trick them."), everyone wants to cash in on what works. That's why you can buy an index fund for stocks involved in auto racing, for companies from Wired magazine's list of technology icons or for the Israeli stock market.

It's why some firms sell unit investment trusts (UITs) -- fixed portfolios of securities that act like index funds -- sporting names such as America's Leading Brands Growth Portfolio and Fortune magazine's America's Most Admired UIT.

And it explains the popularity of exchange-traded unit investment trusts, essentially index shares traded on a stock exchange. The most popular of these are "spiders" (Standard & Poor's Depositary Receipts), which mimic the various S&P indexes, but there are also "webs" (world-equity benchmark shares) that function like single-country index funds. (Picture buying every stock in, say, Malaysia and holding it forever.)

There also are more "enhanced index funds," including Scudder Select 500 and American Century Growth & Income. These funds essentially try to "improve" an index. Think in terms of the Dow's changes: The index would be at much higher levels today had the moves been made a decade ago. Enhanced index funds try to keep an index's winners and kick out the laggards. That's not indexing. Higher costs and lower-than-index performance tendencies show that it's not enhanced, either.

John Rekenthaler, director of research at Morningstar, says, "There are good, bad, silly and ugly indexes out there. Indexing doesn't work just because it's indexing. It needs to combine a good investment idea with low costs. Some of the new indexes don't do that."

When in doubt, look for the biggest, broadest index funds possible -- the "total market funds" -- those with a few thousand stocks that provide broad market representation and a great chance of getting the benefits you want from indexing.

Those are the kinds of indexes you can indeed hold forever.

Next week: Comparing index funds and spiders.

Charles A. Jaffe is mutual funds columnist at the Boston Globe. He can be reached by e-mail at jaffe@globe.com or at the Boston Globe, Box 2378, Boston, Mass. 02107-2378.

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