Canada's "gorilla" technology stock -- Nortel Networks Corp. -- crushed investors yesterday, providing an object lesson in tying one's financial future to the TSE 300 composite index.

When Nortel stock fell $24.55 to $71.55 yesterday, the long-overdue 25% correction in the stock price took the TSE 300 index down with it. Because Nortel makes up 30% of the broadbased TSE 300, the index was dragged down as much as 935 points or 10% before a modest recovery at the end of trading.

Index mutual funds tied to this index -- sold chiefly by the big banks -- would have gone down with the index. Much to the delight, perhaps, of actively managed mutual funds who foresaw the debacle and reduced Nortel exposure over the summer.

Yesterday, Internet chat forums featured predictable criticisms of the dangers of indexing. Indexing or "passive" investing is a low-cost way of investing in the stock market. Instead of using regular "actively managed" mutual funds, index believers simply buy an index fund or exchange-traded fund that tracks the performance of the TSE 300 or some other stock index.

That strategy has worked to the benefit of most investors in the recent years of the bull market. Until this week, Nortel's dominance in the TSE 300 meant investors in Canadian index funds enjoyed far better performance than actively managed Canadian equity funds.

That's because active funds are prohibited from owning more than 10% of any one stock. So when Nortel was soaring, index funds got a better bang for the buck.

The shoe was on the other foot yesterday, as believers in active management and especially the "value" school of investing couldn't refrain from saying, "I told you so."

But while investors with significant holdings in Nortel-heavy index funds may have been bruised when the gorilla fell on them yesterday, it's hardly proof that index investing around the world is a bad thing.

The fact is the Canadian example is atypical in two respects. First, most foreign markets -- notably the United States -- are far more liquid than the Canadian one. No single stock would be more than about 7% of an index like the S&P500.

Nortel makes up an even greater proportion of Canadian index funds in the case of products which focus only on the top 60 or 40 stocks, rather than 300. Thus, Nortel accounted for as much as 42% of Canada's largest domestic equity fund, Barclays' i60s. As of yesterday, the i60s exposure to Nortel was cut to just 33%.

The second anomaly in Canada is the requirement that registered retirements savings plans (RRSPs) be invested 75% in Canadian securities (although there are numerous ways to escape that restriction.)

If someone were invested exclusively in stocks in their RRSPs and used only Canadian index funds, they could have had virtually 30% of their retirement savings exposed to Nortel. Little wonder that even index proponents viewed the NT-TSE situation as "an accident waiting to happen."

An indexing advocate going by the handle Bylo Selhi (www.bylo.org) disputes this theory. "No. Nortel was an accident waiting to happen for those who paid more than $50 a share. Those who own the TSE index haven't lost anything provided they have the stomach to hang on for the ride. Those who panic will lose."

Index investing should be done with attention to such fundamentals as portfolio construction, asset allocation and geographical diversification. Thus, if the hypothetical RRSP investor above had a more prudent 50/50 mix of stocks and bonds, they would have had a maximum exposure to Nortel closer to 15%. Furthermore, had they been in such products over the past 10 years, they would have done better than virtually any active mutual fund or stock portfolio, says Eric Kirzner, an indexing believer who is also a University of Toronto professor.

For investors who owned Nortel outside RRSPs, in so-called taxable portfolios, Nortel would be more of a problem if they had bou the TSE was at their highs back into those products yesterday. So far, the "buy the dip" mentality has served investors well in the long bull market.