S&P 500 Funds: Money Flows Out Even While They Grow

January 01, 1999

As big stocks soar ever higher, more money is drawn to mutual funds that mimic the performance of the Standard & Poor's 500-stock index. That money spurs the index's stocks higher, drawing in even more cash.

Or so the theory goes.

But according to Vanguard Group, the fund company that runs the Vanguard 500 Index Fund, which replicates the S&P 500, money is really going out of such investments, not in.

Vanguard contends that while assets invested in S&P 500 index funds in general have indeed risen, the increase is due entirely to increases in the value of the stocks in the funds themselves, and not the result of an increase in investors' cash contributions. Vanguard, Malvern, Pa., says that investors have withdrawn more of those assets than they put in over the past three years. It notes that investors withdrew $67 billion of S&P-500-indexed assets in the first six months of 1998, compared with a $33 billion net outflow in 1997. The company didn't have more recent data. As of June 30 last year, total assets indexed to the S&P 500 were $706 billion, while the Vanguard 500 Index Fund had assets of $64.3 billion at that date. At the end of  February, the Vanguard 500 had more than $78 billion in assets.

While individuals may be pouring cash into so-called retail, or small-investor-oriented, S&P 500 index funds, such as Vanguard's, a bevy of institutional investors, including pension funds, separate accounts and collective trusts, are taking money out faster. Together those large institutional investors own about 85% of all assets indexed to the S&P 500, Vanguard says.

'We're only seeing the tip of the iceberg, which is the visible S&P 500 mutual funds,' says Gus Sauter, managing director at Vanguard. 'But under the water, large pension plans are lessening their concentration in S&P 500-indexed assets' out of concern that the huge rally in the S&P 500's large-capitalization stocks has distorted their portfolios.

Institutions now appear to be diversifying into broader-market index products that include small-cap and midcap stocks, though such moves aren't necessarily a panacea for the lagging small-cap and mid-cap markets, since the broader indexes still tend to be skewed to larger stocks.

Nevertheless, the concerns of institutional investors may be a lesson to individual investors, Sauter says. 'We try to caution investors that the S&P 500 isn't the entire market,' he notes. 'I think it's healthy' that institutional investors are 'becoming more diversified.'

Data from Standard & Poor's, which runs the S&P 500 index itself, bolster Vanguard's figures. Elliott Shurgin, vice president of index services at S&P, says that the percentage of assets indexed to the S&P 500 have remained steady at about 7.5% of all U.S. stock investments for the past few years.

All of this means that S&P 500 stocks aren't getting the big boost from new money that investors may have thought. Institutional money that might have been earmarked for the S&P500 a few years ago now is being diverted to other investments, including bonds, small stocks and foreign stocks.

At the $110 billion New York State Common Retirement Fund, for instance, the trustees haven't allowed the percentage of the fund's portfolio indexed to the S&P 500-40%-to creep up for at least the past three years, says Jeffrey Gordon, a fund spokesman. Gordon notes that if the S&P 500 portion rises, those assets are directed elsewhere into investments such as real estate or bonds.

Underlying the reallocation trend is a concern over the high valuations of many S&P500 stocks, such as America Online and Microsoft. At the $49 billion State Teachers Retirement System of Ohio, trustees last year decided to switch from indexing their U.S.-stock assets to the S&P500 and moved to the broader benchmark of the Standard & Poor's 1500, precisely because of mounting concerns over pricey large-cap stocks.

Indeed, broader market indexes that don't just represent large-cap stocks are growing increasingly popular among institutional investors. The Russell 3000 and Wilshire 5000 indexes, in particular, which have exposure to small-cap and midcap stocks, are favored alternatives to the large-cap-focused S&P500, in which stocks have an average market capitalization of about $20 billion. Consider that the $152 billion California Public Employees' Retirement System, the largest public pension fund, indexes its U.S.-stock assets to the Wilshire 2500, says spokesman Brad Pacheco.

James Parsons, head of equity management at Barclays Global Investors, a large provider of indexed products for institutional investors, says more than half of his clients over the past 12 months have requested broad-market index products rather than S&P 500 index accounts. That compares with just one or two clients inquiring about broad-market index products five years ago, Parsons says.

What these institutional investors are getting in the way of diversification, they're losing so far in terms of performance. By turning their attention to lagging asset classes, many have missed out on a portion of the S&P500's giddy rise. Last year, for instance, the S&P500 delivered a hefty 28.58% return, compared with the smallcap Russell 2000 Index's loss of 2.55%. Over five years, the performance difference is equally stark: The S&P 500 produced an average 24.13% return annually over the five years ended in February, compared with the Russell 2000's average annual return of 9.69% over the same period.

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