On the Verge of a Record, S&P 500 Index Can't Get No Respect

The S&P 500 index is poised to post a record fifth-straight year of 20%-plus returns.

Ho hum.

Until this year, the index was a pacesetter and a mutual fund manager's arch nemesis. But in the year of the triple-digit return, beating the S&P 500 seems like no big deal. As of last week, more than 90 mutual funds were returning 100% or better for 1999, and the average diversified domestic fund (24.2%) was better than the benchmark (20.1%).

But even though the S&P 500 may seem slow and plodding this year next to tech-driven high-performing indices, it still deserves attention. In many ways, it's the 300-pound gorilla no one's talking about. More than $228 billion is invested in S&P 500 index funds. It's the fifth-largest among Lipper's 42 stock-fund categories.

This year, $28.7 billion in investment has flowed into S&P 500 index funds through Oct. 31, according to Boston fund-researcher Financial Research. That dwarfs the record $17.8 billion net investment in the red-hot technology sector this year.

Index Investing Net investment in S&P 500 index funds

Data as of Oct. 31. Source: Financial Research.

And then there's that potential record. S&P 500 index funds have returned 244% over the past five years, more than doubling their 11% average annual returns since 1926, according to Ibbotson Associates in Chicago. In any year other than this one, that would be considered impressive.

"It's incredible. It's surprised me," says Gus Sauter, manager of the $98.2 billion (VFINX)Vanguard 500 Index fund, which may kick off the new year by unseating (FMAGX)Fidelity Magellan as the largest mutual fund in the nation. On Nov. 30, the Vanguard fund was only about $900 million behind Fidelity's flagship behemoth.

From 1993 to 1998, the index routinely beat the average diversified U.S. stock fund. And the same holds true this year -- 55% of U.S. diversified stock funds trail the index's returns, according to Lipper. That highlights the fact that the average fund return is inflated by a relatively small number of funds' outlandish returns.

Beating the Average The average U.S. stock fund is beating the S&P 500 this year for the first time since 1993
Year	S&P 500	U.S. diversified stock funds
1999	20.1%	24.2%
1998	28.6	14.9
1997	33.4	24.6
1996	23	19.9
1995	37.6	31.7
Data as of Dec. 23. Source: Lipper.

If the S&P 500 is on such a tear, why is it lagging the Nasdaq Composite Index and so many funds?

Two words: tech fever.

This year many managers have ridden the tigers of new, small- or mid-cap tech stocks to explosive returns. The average science and technology fund is up 128% this year, according to Lipper, and the average growth fund has more than 30% of its assets in tech stocks.

By comparison, the predominantly large-cap S&P 500 has only 23% of its assets in technology, according to Chicago fund-tracker Morningstar.

The Nasdaq's bias toward smaller technology companies puts the market's wind firmly at its back in 1999. In a testament to that wind's gale force, investors seem to be taking 20% returns for granted.

"Seems good isn't good enough anymore. But no one should be crying about these returns," says Jim Folwell, an analyst with Boston fund-researcher Cerulli Associates. Folwell admits that he's started casting a critical eye on funds in his own portfolio with returns in the teens.

Investors disappointed with their index fund's performance this year might take solace in the fact that the S&P 500 offers more sector diversification and downside protection. And though the S&P 500's average price-to-earnings ratio is historically high at 30, the Nasdaq 100's P/E ratio is 79.5, according to First Call/Thomson Financial.

With tech stocks selling at such high prices, it wouldn't take much to trigger a selloff.

"If I were a betting man, I'd have a hard time betting on more triple-digit returns from small tech stocks with no business behind them. A lot of the companies in the S&P 500 are large, real companies with earnings, that are less vulnerable to the bubble bursting," says Edward Rosenbaum, Lipper's research director.

A bursting tech bubble could be particularly painful since many investors aren't factoring a downturn into their financial plans. The average investor with less than five years' investing experience expects 23.2% returns over the next 12 months, according to a PaineWebber (PWJ) study released Monday.

But investors who plan on above-average returns do so "at their peril," says Frank Armstrong, a Miami-based financial planner.

Peril might not be too strong a word if indices return to their average levels. At Monday's close, the Nasdaq Composite was up 81%, more than four times its average annual return in the previous 10 years, according to Morningstar. Vanguard's Sauter says he wouldn't be surprised by 7% to 8% annual returns for the S&P 500 over the next 10 years.

In the meantime, says Sauter, investors' apparent lack of Y2K panic gives the S&P 500 a shot at posting a record fifth-straight 20% return.

The question is, will anybody break out the champagne to celebrate?

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Catch Ryan Jacob, portfolio manager of the Jacob Internet Fund, this weekend on "TheStreet.com" on Fox TV. Special New Year's weekend times: Saturday at 6 p.m. ET and Sunday at 11 a.m. ET.

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