Keep Swimming in That Index Pool

Index funds are supposed to be simple.

Let's keep it that way.

On the heels of its middling 20% gain in 1999, the S&P 500 index has fallen 5.8% this year, and plenty of people are stepping up to predict the demise of index funds that track the benchmark.

Though S&P 500 index funds still command $232 billion in assets, investor zeal is fading as tech stocks hog the spotlight. In January, S&P 500 index funds took in $2.5 billion in net assets, down from $5.7 billion in January 1999, according to Financial Research in Boston.

In late February, a Wall Street Journal story highlighted waning investor interest in index mutual funds. Plenty of pundits have stepped up to sound the death knell. Jim Cramer himself wrote a column last week called Don't Drown in the Index Pool, which told you to sell your S&P 500 index fund and put your money into something with more tech.

Don't listen to them.

Don't dump your S&P 500 index just because its performance has turned over the past few months. To turn any index fund into a trading vehicle is like trying to drag race with your Dodge Dart.

It's just downright ridiculous.

The whole point behind buying an index fund is to own a large piece of the market and -- for better or worse -- and ride it over a long period of time, at least 10 years. Index funds cost less than actively managed funds and provide broad diversity.

By frequently switching from one narrow part of the market to another, say from B2C (business-to-consumer) Internet stocks to B2B (business-to-business), you're just guessing which sectors are going to outperform in the near future. That type of maneuvering defies the very reason you'd buy an index fund in the first place: You don't know which stocks will outperform at any given time, so you're buying the entire market. Vanguard's indexing guru Gus Sauter likes to say, "Investing is a marathon, not a sprint."

"If you want to take a huge bet on a particular sector, you probably don't want an index fund," says Jim Troyer, a principal in Vanguard's core management group. "If you think there's a possibility you may be wrong, you want diversification."

None of us is prescient. And an S&P 500 index fund will still give you a hedge against being wrong. It owns five times as many stocks as the Nasdaq 100 and represents 70% of the U.S. stock market in terms of market cap, says Troyer.

Yes, the S&P 500 is off this year. Large-cap stocks are hurting and passing on that pain to S&P's benchmark index. At the end of February, 76% of active fund managers were beating this index, according to Morningstar.

But their recent success will be fleeting. Trust me.

A majority of active stock fund managers has beaten the S&P 500 in just 10 of last 30 years.

The Wilshire 5000, an all-encompassing index that includes more small- and mid-cap stocks, has experienced similar success. "Since its inception nearly three decades ago, the Wilshire 5000 has beaten the median money manager in 21 of 29 years," wrote Sauter in a January report.

Over the past 10 years, this expansive index beat 72% of general equity funds, according to Vanguard.

Even if you're a believer in indexing, you might think you aren't getting enough tech exposure in the S&P 500.

Merrill Lynch derivatives strategist Diane Garnick certainly agrees.

At the beginning of March, about 34% of the index was in tech stocks.

"On an absolute basis, the sector's weighting seems quite lofty. ... However, on a relative basis, the S&P 500 is underweighted technology," Garnick wrote in a research report from early March. Compared with the 500 biggest U.S. stocks (by market cap), the S&P 500 index "is short technology by more than 5%."

Missing from S&P 500 are stocks associated with the New Economy -- primarily Internet and software-related stocks, says Garnick.

Of the 10 largest computer software and services companies by market cap, five aren't in the S&P 500: Level 3 Communications (LVLT), Veritas Software (VRTS), Ariba (ARBA), Siebel Systems (SEBL) and Exodus Communications (EXDS).

But that weakness doesn't mean you should sell your S&P 500 index fund to buy the Nasdaq 100.

If you want more tech and you like indexing, you can add another tech-specific basket rather than forsaking your 500 fund. The Nasdaq 100 may give you too much tech on its own. Technology commands 81% of this index (which has a tracking stock (QQQ)).

If you want to selectively increase your tech exposure, you can add the Nasdaq 100 or maybe purchase one of Merrill Lynch's seven exchange-traded HOLDRs baskets, which cover several select areas of tech.

"People shouldn't commit 100% of their assets to any one single index," says Garnick. "You should look for diversification among the indices. ... It can't be large-cap growth forever, and it can't be tech forever either."

Your S&P 500 fund may not give you everything you want, but you don't have to throw it out and start all over.

For many investors, an S&P 500 fund is the only index option they'll find in their 401(k) plans. "An equity index fund is a very common option in 401(k) plans and typically that's the S&P 500 type," says Rich Koski, a principal at Buck Consultants, a benefits consulting firm in New York.

Don't let Cramer scare you away from using it.

The alternative: Picking a fund manager who may or may not beat the market in the years to come. Maybe you'll actually find someone who can. But how long is that guy going to be around?

The S&P 500 isn't going anywhere.

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Are you selling out of your S&P 500 index fund? Tell me about it. What are you buying instead?

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