Investors passionately wedded to S&P 500 index funds are being put to the test.
The conventional wisdom about these mutual funds is well-known: For the past few years, mutual funds designed merely to track the movement of Standard & Poor’s 500-stock index have been outstanding investments. Not only do they carry lower fees because they aren’t “actively managed”–in other words, they don’t do stock picking–but they also have consistently outperformed many of the actively managed U.S.-stock mutual funds over the past few years. According to Morningstar Inc., only 90 out of 1,022 actively managed U.S. diversified stock funds beat the returns of S&P index funds in the five years through the end of June.
In the past few months, however, everything hasn’t gone smoothly for S&P 500 index funds. During the second quarter, the stock market flip-flopped as concerns over U.S. companies’ earnings and the Asian economic crisis mushroomed. The S&P 500 index rose only 3.17 percent in that period, thus giving investors in S&P 500 index funds one of their poorest quarterly returns for several years. (Still, the S&P index beat actively managed funds in the quarter.)
And some economists and fund managers are concerned that the volatility in the major indexes will persist over the next few quarters. In a recent survey of 50 economists, for instance, a majority of respondents said they believe the Asian crisis will hurt the U.S. in the next six to nine months. That may damp the earnings of many large companies that make up the S&P 500, sending share prices and the index down.
What’s a lover of S&P 500 index funds to do in such uncertain times? For a start, don’t keep rose-colored glasses on. Here’s a rundown of some common myths about the index funds:
– Myth No. 1: S&P 500 index funds stand alone. S&P index funds are sometimes portrayed as stand-alones because they give investors a broad exposure to a benchmark index. Yet owning only funds that track the S&P 500 index means that individuals have 100 percent of their portfolio exposed just to large-capitalization stocks. And any time investors hold only one type of asset class, they risk being pummeled if the asset class runs into trouble.
“It’s a myth to think that (S&P) index funds are all you need,” says Robert Bingham, a principal at Bingham, Osborn & Scarborough, a San Francisco advisory firm. “If you want just one fund, you are better served by an asset-allocation fund or balanced fund” that invests in bonds as well as stocks.
– Myth No. 2: S&P 500 index funds are conservative. Just because a fund emulates a benchmark index doesn’t mean it is a stable investment. Because the S&P 500 is made up of a series of large-cap companies, an investor who holds an S&P index fund will be subject to the same risks and volatilities that come along with large-cap stocks. And currently, the risks associated with large-cap stocks appear to be growing.
Consider the valuations and average earnings growth forecast for companies in the S&P. Todd Feltz, an investment adviser in Omaha, Neb., notes that the S&P 500 is currently at around 25 times earnings, which is historically regarded as expensive. In addition, projected average earnings growth from S&P 500 companies is declining. Feltz notes that many large companies generated healthy profit gains in excess of 20 percent in 1997 but that the consensus earnings estimate for 1998 has dropped to 11 percent.
What’s more, S&P index funds aren’t as diversified as they may appear to some investors. That’s because the top 25 companies in the index represent more than a third of the market capitalization of the S&P 500, says Feltz. Consequently, instead of getting broadly equal amounts in 500 stocks, an investor is really getting huge chunks in a handful of large stocks such as Coca-Cola and just a smattering of everything else.
In a report on large-cap growth and value funds, fund-research firm Morningstar in Chicago notes that there are many large-cap funds that are far less risky than index funds. Indeed, Morningstar found 125 other large-cap funds that are less volatile and more conservative than Vanguard Index 500 Portfolio, one of the best-known S&P index funds.
“You can do better in terms of finding a conservative and less volatile fund,” says Kevin McDevitt, a Morningstar analyst. “But you may have to sacrifice beating the S&P’s returns.”
– Myth No. 3: S&P 500 index funds are always cheap buys While S&P index funds are usually praised for their low transaction costs, Franklin Allen, Nippon Life professor of finance and economics at the Wharton Business School in Philadelphia, says it is possible that trading costs of index funds can rise in a volatile market.
In a choppy market, he says, index funds have to trade constantly to keep up with the shifting changes in the market capitalizations of different companies. Ultimately, the cost of increased trading may get passed along to the consumer, Allen cautions.
That isn’t to say investors should divorce themselves from S&P index funds altogether. Conceptually speaking, index funds remain a solid investment option, especially with their proven long-term track record. But experts are concerned that the expectations the vehicles have raised in the past few years because of their spectacular returns have become too inflated.
For investors who are jittery about the risks of an S&P index fund, financial planners recommend cutting back on that holding and instead getting into more conservative vehicles. Many actively managed large-cap stock funds, for instance, have a lower volatility because a chunk of their portfolio is in cash.
Feltz, the Omaha planner, recommends getting into bond funds for safety now. For those with a contrarian bent, he also suggests looking at international and emerging-market stock funds. “I’d start to whittle away at my percentage in the S&P 500 now,” says Feltz. “Never have more than 10 percent of a portfolio in any one asset class.”
