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Journal of Indexes

Investor Fixation On Index Funds Wanes

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Are investors just fair-weather friends when it comes to plowing money into index mutual funds?

Index funds were hot when they were delivering some of the best returns in the mutual-fund world. But now that many have been losing money alongside their market benchmarks, even as many other mutual funds were holding up better, investors are suddenly less entranced with all the practical attributes of these portfolios - things like low costs and tax efficiency.

At the end of February, more than 75% of active managers were beating the S&P500. Not since 1977, when 88% of actively managed portfolios bested the benchmark, have so many pulled off the feat. Indeed, for most of the past two decades, the indexes have had the upper hand.

In the past several months, investor appetite for index mutual funds, which once seemed so insatiable, has diminished considerably. Last December, investors pumped 60% less money than they did in January 1999 into index mutual funds, $3.3 billion compared with $8.3 billion, according to Financial Research Corp., a fund tracker in Boston. Industry experts say the trends continued into this year amid a steep downturn for big-company stocks.

Most hurt by the slackening flows: portfolios that track the Standard & Poor's 500 stock index. In December, just $627.6 million went into S&P500 index funds, the biggest group within the index category. That is down 89% from $5.67 billion in January 1999, calculates Financial Research. While such funds nabbed more than one of every five dollars that went into stock mutual funds in early 1999, their share was just 10% in December.

The S&P 500 funds began losing their luster late last year amid some uncustomary weak performance. The average once was up 20.2% for 1999, none too shabby but far short of the average 27.7% of so-called actively managed mutual funds, many of them stuffed with soaring technology shares, according to tracker Lipper Inc.

While $350 billion, or about 8% of total stock mutual-fund assets, now rests in index mutual funds, the ebbing fund flows indicate that "many investors weren't index believers; they were just performance chasers," says John Rekenthaler, research director at fund tracker Morningstar Inc.

In general, even the biggest boosters of index mutual funds concede that support for the investment strategy isn't as strong as it appeared at times earlier last year, when money gushed in.

"There is a realization now that indexing is not a home-run-hitting strategy, but that it is something to be in for the long haul," says Gus Sauter, indexing head at Vanguard Group. An indexing specialist, the Malvern, Pa., firm boasted the top-selling mutual fund, Vanguard 500 Index Fund, for six months in 1999 until this past November, when it was displaced by a handful of roaring tech-laden funds including Janus Global Technology Fund and Fidelity Aggressive Growth Fund.

Sauter argues that the drop in flows for the big-company S&P 500 fund is a healthy pause, and notes that various Vanguard index funds have seen more net new money, not less. In December, for instance, Vanguard Growth Index Fund attracted a net $601 million, up from $469 million a year ago. And Vanguard Total Stock Market Index Fund took in a net $762 million, nearly triple its year-earlier draw, according to Financial Research.

But, for now, the overall reduced appeal of index mutual funds is music to the ears of executives at many asset-management firms, which earn fatter management fees from portfolios headed by stock pickers, as well as legions of financial advisers, whose fees are based partly on their ability to identify funds with hot stock pickers.

"I had a lot of clients who wanted index funds last year but now want actively managed funds instead," says David Bugen, an adviser in Chatham, N.J., who has long advocated owning both index and actively managed funds. Adds Deena Katz, an adviser in Coral Gables, Fla.: "There were a lot of financial planners who embraced indexing entirely, and I think that was a mistake."

 

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