From the Archives: Getting Going

Getting Actively Passive:
Index Funds Still Win -- If You
Go Beyond the S&P 500

By JONATHAN CLEMENTS
Staff Reporter of THE WALL STREET JOURNAL

Index funds had a wretched 2004 -- or so it seems. Consider:

• Diversified U.S. stock funds climbed 12%, comfortably ahead of the Standard & Poor's 500-stock index's 10.9%.
• Today's most celebrated fund manager, Legg Mason Value Trust's Bill Miller, outpaced the S&P 500 for the 14th consecutive year.
• Indexing's basic approach -- weighting stocks based on their market value -- came under attack, with critics charging that there are better ways to index.

So is it time to give up on good old index funds? You've got to be kidding.

• Standing tall. Whenever index funds come under assault, you ought to be suspicious, because the critics aren't exactly disinterested observers. Overconfident investors consider index funds an affront to their machismo, while Wall Street sees them as a threat to its profit margins because the Street can make a whole lot more money flogging actively managed funds.

Indeed, index funds are often dismissed as somehow anti-American and anticompetition. But in truth, when you index, you are acknowledging that Adam Smith's invisible hand really works, that the stock market efficiently sets prices and that your best bet is to give up on costly efforts to beat the market.

"Who's left that believes that markets don't work?" asks Rex Sinquefield, co-chairman of Dimensional Fund Advisors in Santa Monica, Calif. "Apparently, it's only three groups -- the North Koreans, the Cubans and the active managers."

The brutal reality: A low-cost index fund will always outperform the collective performance of active investors in the same market sector. Before costs, these active investors will -- as a group -- match the sector's performance. After costs, they will fall behind. That's where index funds get their edge. They also earn the sector's performance, but they incur far lower costs.

So why do index funds look so bad today? If you want to look tall, stand next to short people. If you want to beat the market, pick a poor-performing index.

Thanks to the proliferation of exchange-traded index funds, there's now an astonishing array of index funds. Yet almost everybody seems to associate indexing with the S&P 500 -- and that's where the mischief begins.

• Big picture. Sure, the S&P 500 accounts for 75% of U.S. stock-market value. But how the other 25% performs is critical. If small U.S. stocks outperform the big companies in the S&P 500, anybody owning smaller companies has a good shot at beating the S&P 500.

So what happened in 2004? You guessed it. Small stocks outperformed large stocks, so stock-fund managers appear to be market-beating geniuses.

But if, instead, you compare funds to the broader Dow Jones Wilshire 5000 "total market" index, the results don't look nearly so spiffy. Last year, the 12% clocked by diversified U.S. stock funds lagged behind the Wilshire's 12.6% gain.

The performance is even more disheartening if you go category by category, which is what Standard & Poor's does. S&P, a unit of McGraw-Hill, slots U.S. stock funds into nine categories based on their stock-picking style and the size of company bought.

Last year, a majority of funds failed to beat their benchmark index in eight of the nine categories. The five-year results are equally bad, with funds again striking out in eight of the nine categories.

• Miller time. There are, of course, winners. That brings us to Legg Mason's Mr. Miller. I noted in a 2002 column that, with thousands of funds on offer, it was no great statistical surprise that one manager had such a dazzling record.

Since then, Mr. Miller has posted three more market-beating years, and I would argue that you can no longer explain his record in terms of luck alone (though, if you were feeling churlish, you might note that his 2004 gain of 12% trailed the Wilshire 5000).

Still, today's purchasers can't buy Mr. Miller's past performance. What matters is the future. Mr. Miller is clearly a talented stock-picker. But does he have sufficient skill to beat the market with a fund that now has $17 billion in assets and whose retail shares still charge a hefty 1.7% in annual expenses? It will be fun to watch. But I don't plan to bet any of my own money.

• Weighty issues. Last year, index funds also came under attack from folks who argued there are better ways to index.

For instance, Research Affiliates of Pasadena, Calif., analyzed the past 42 years and found you could have beaten a traditional index fund, which weights stocks by their market value, by instead weighting stocks using fundamental factors such as revenue and operating income.

Meanwhile, in another hit to traditional indexing, Morgan Stanley Equally Weighted S&P 500 Fund D shares and Rydex S&P Equal Weight ETF -- both of which divide their money equally among the S&P 500 stocks -- turned in market-beating gains of more than 16%.

I find all this intriguing. There is, however, no free lunch. When you buy a low-cost total-market index fund, you know you will get the market's performance and you know you will outperform most active investors. But as soon as you stray from a market-weight approach, this certainty slips away and you run the risk of lagging behind the broad market, just like all those actively managed funds.