Stock Pickers Par Excellence - Standard and Poor's 500-Stock Price Index - Brief Article

Kiplinger's Personal Finance Magazine, August, 1999 by Manuel Schiffres

Fidelity, T. Rowe Price, Charles Schwab, Vanguard and Wilshire Associates offer funds that emulate the Wilshire 5000 index. The index (which actually contains more than 7,000 stocks) returned an annualized 21.2% over the five-year period to June 14. Vanguard Total Stock Market Index, the oldest of these funds, uses sampling techniques to pick about 3,000 of the stocks in the index. It has returned about two percentage points more per year than the index itself.

HOW NOW FOR THE DOW?

When you think about it, the Dow Jones industrial average is really a funky barometer of the market's climate. It consists of only 30 stocks. It includes relatively minor players such as Goodyear Tire and Union Carbide, and excludes such new-age titans as Microsoft and Intel. And the Dow is price-weighted, meaning that a stock's price counts for more than its market capitalization.

Because of its membership, the Dow is a bit more value-oriented than the S&P 500. In years like this one, when large, undervalued stocks have done well, the Dow looks better. In years like 1998, when a narrow group of growth stocks led the way, the Dow can trail the S&P badly.

Still, over the past five years to June 14, the Dow has returned a not-too-shabby 23.2% per year compounded. One fund, the relatively new Waterhouse Dow Jones Industrial Average Index, tracks the Dow. In its brief history, the Waterhouse fund, with an expense ratio of 0.25%, has done a decent job of copying the Dow's performance.

The supremacy of indexing isn't as clear-cut with stocks of small companies. Small-company stocks do tend to be more difficult and costly to trade than large ones (advantage: index funds). But small stocks are less widely followed than the Mercks and Intels of the world, giving a theoretical edge to diligent managers and analysts seeking underpriced stocks (advantage: actively managed funds).

Over the past five years, anyway, the data on small-company stock funds is mixed. We looked at the universe of such funds tracked by Morningstar, which categorizes funds not only by the size of the stocks they own but by the manager's style: value, growth or blend. In both the value and blend categories, a majority of actively managed funds trailed their benchmarks over the past five years. But in the small-company growth category, a slight majority of funds outpaced their index over the same period. (Bogle contends that actively managed small-company-stock growth funds look better versus their benchmarks because the funds are much more volatile--and hence, riskier--than their indexes.)

Note that different funds track different indexes. Vanguard Small-Cap, for instance, follows the Russell 2000, while funds offered by California, Dreyfus and Galaxy track S&P's Small Cap 600 index (Galaxy's fund is the cheapest of the second group, with an expense ratio of 0.4%.)

One thing is certain: Actively managed funds fare better against S&P 500 index funds when smaller stocks perk up. Joseph Mezrich, head of quantitative analysis at Morgan Stanley Dean Witter, says that, on average, the typical fund holds stocks with market values below that of the S&P 500. Therefore, most funds lag the index "when the Nifty 50 stocks are the only game in town," he adds. Indeed, between March 29 and June 9, the Russell 2000 small-company stock index trounced the S&P 500, 11.4% to 1%. During that period; 71% of diversified U.S. stock funds topped Vanguard 500 Index.