There's More Than One Way to Index Your Portfolio

Investors who put their money into index funds that track the S&P 500 did well in 1998. But does that mean you should sell your actively managed funds and stuff all your money into an S&P 500 index fund? No way, financial planners say.

The mammoth $69.5 million (VFINX)Vanguard Index 500 returned 28.6% in 1998, according to Lipper. That's a lot better than your average stock fund, which struggled to break 10% in returns last year.

In fact, the Vanguard Index 500 outperformed all but 12% of actively managed equity funds in 1998. Even when you exclude sector, international and other specialized funds from the equation, the index fund still beat all but 17% of the competition.

And this wasn't just a one-year phenomenon. The S&P 500 has posted four straight calendar-year gains of 20% or more. But before you buy based on past performance, you should take a peek under the hood of your S&P 500 index fund to see if the engine's still well tuned.

"If you decide to cash in your chips and buy an index, especially the S&P 500, you're playing the momentum game," says Steve Janachowski, a financial adviser at Brouwer & Janachowski in Tiburon, Calif. With all the hype index funds have gotten lately, a sort of mania has developed around them, he says. This, in turn, has built up a get-in-while-you-can mentality. S&P index funds took in a collective $22.4 billion for 1998 through Nov. 30, according to Lipper.

"You're jumping on board and hoping you can jump off before it crashes," Janachowski says. "That's what you're buying when you buy the S&P right now."

30 to 50 Stocks Dominate

Many index-watchers point out that while the S&P 500 outperformed the market in 1998, the top 30 to 50 stocks that make up the S&P 500 have actually outperformed the index itself. And because their huge market caps give them a disproportionate weighting in the S&P 500, they have a disproportionate effect on its overall return. In fact, according to a report from Heartland Advisors, Milwaukee, if you had invested in the bottom 250 stocks that make up the index, you would have had a negative return for 1998 through Dec. 15.

"It's just been the top 50 stocks in America that have done anything," says Chris Cordaro, an investment adviser with Bugen Stuart Korn & Cordaro in Chatham, N.J. "If you put your money in the S&P 500 index fund, you're really overweighting those stocks."

If those 50 stocks turn south, so could your mutual fund returns. So investors who are looking for diversification through the S&P 500 index may be getting a lot less than they think.

Still, while throwing all your money onto the S&P train might not be the best thing to do (after all, when was the last time a financial planner ever told you to put all your eggs in one basket?), advisers say you still can satisfy your need to play the indexing game and spread your money around sufficiently. And you shouldn't disregard the S&P 500 entirely.

Other Types of Index Funds

"There are still some reasons to maintain some allocation [in the S&P 500], if you focus in on some of the small-cap index funds as well," Cordaro says. He recommends the $1.3 billion (DFSCX)DFA U.S. 9-10 Small Company fund, which offers some broader, smaller-cap diversification than the often-cited indices.

The 9-10 U.S. Small Company, available only through financial advisers, invests in companies that have market caps comparable with the ninth and 10th deciles, or smallest 20%, of stocks traded on the New York Stock Exchange. Its return this year is negative 7.3%, which reflects the pummeling that small-caps have taken at the hands of their bigger-cap brothers. But if the tables were turned, wouldn't you want to have at least some exposure to small-caps?

And the fund has another advantage besides its return, Cordaro says. Due to lower liquidity in small-cap markets, it can have a negative trading cost, because its managers are able to barter for a lower price when buying large blocks of small-cap stocks they track. The fund's total expense ratio is a modest 0.6%.

Cordaro likes all things big and small when it comes to indexing, but he doesn't have much of a taste for the middle.

"I tend to focus on either end, because what happens is either small[-cap] does well and large[-cap] does poorly, or vice versa," Cordaro says. "It's rare that the mid-caps do well and small- and large-caps do poorly. So you're getting more diversification benefits by highlighting either end of the market-cap spectrum."

For his part, Janachowski says, "you could still put together an intelligent index fund portfolio" without relying solely on the S&P 500. (He calls this index "a big temptation" for investors focused on keeping up with the indexing crowd.)

When picking index funds, he likes the Vanguard Group and lists its different indices in rapid progression. He likes a mid-cap component for a diversified portfolio and touts Vanguard's $165 million (VIMSX)Mid Capitalization Index.

For small-caps, he recommends funds that track the Russell 2000 index, such as the $2.6 billion Vanguard (NAESX)Small Cap Index. This fund, as you would expect, has a negative year-to-date return of 2.6%, reflecting the overall trend of the index it follows. But there are other small-cap indices to choose from. Vanguard's (VISGX)Small Cap Growth and (VISVX)Small Cap Value index funds, which were launched in May, track the S&P SmallCap 600/BARRA growth and value indices.

Vanguard, of course, has been introducing investors to indexing with zeal. It has an index fund to suit the whims of almost any investor. Not satisfied with the diversification of the S&P 500? Try the $8.5 billion (VTSMX)Total Stock Market Index, which holds 1,900 of the largest stocks in the Wilshire 5000 index. Don't want to overweight yourself with U.S. stocks? Check out the $989.6 million (VPACX)Pacific Stock Index, which invests in that region's component of the Morgan Stanley EAFE Index. Want to make a sector bet? Look at the $956.7 million (VGSIX)REIT Index. Want to get away from stocks? Vanguard has plenty of fixed-income index funds to choose from.

Vanguard Isn't the Only Indexer

And while Vanguard may be the first word in indexing, it isn't the last. There are almost as many kinds of index funds as there are different kinds of investors. Look at Guinness Flight's newly launched Wired Index fund. It tracks high-tech and Internet stocks handpicked by that publication. Socially responsible investors can look to the $386.4 million (WAIDX)Citizens Index or the $635.8 million (DSEFX)Domini Social Equity fund. (Both funds essentially cherry-pick the S&P 500 for socially responsible companies and blend them with other stocks they've deemed socially responsible.) Utility freaks can check out the $58.7 million (IUTLX)Galaxy II Utilities Index; it tracks the S&P Utilities Index. The $1.2 billion (SNXSX)Schwab 1000 fund invests in the 1,000 largest U.S. companies. The $60.7 million (PPTIX)Principal Preservation PSE Tech 100 Index tracks the Pacific Stock Exchange Technology Stock Index.

Of course, another way to diversify away from the S&P 500 is to split up your portfolio into different kinds of funds. Sheldon Jacobs, editor of the No-Load Fund Investor newsletter, says a model portfolio could include a 50% allocation to index funds with the rest split among other, more specified funds. This includes concentrated funds, which may hold fewer than 20 stocks. Paired with an index, Jacobs says, they can be a good way to beat the S&P 500 altogether.

"For me, the way to beat the index is to pick a few good focused funds that hold 15 to 30 stocks," Jacobs says. "That's the way to try to beat the index in my opinion."

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