Value Indexing: An Idea Whose Time Has Come - TheStreet

For fund investors sold on the indexing idea, here's a move worth considering: investing in indices of value stocks.

The reason why this concept makes particular sense now is that with the huge rise in growth stocks from 1995 to 1999, the

S&P 500

and the

Wilshire 5000

-- the most common indices used as the basis for funds -- have both become heavily tilted toward growth. Indeed, when growth stocks took a beating last year, they took both those indices down with them, with the S&P 500 losing 9.1% and the Wilshire 5000 down 10.6% for year 2000.

Value stocks have also outperformed their growth brethren for the past 15 months, although it's not clear whether value stocks will continue to prevail. In the past, when value stocks have come into style, they've tended to lead the market for years at a time, including the period from 1974 through 1980, 1982 to 1985 and from 1991 to 1994, according to the

Leuthold Group

.

But more recently, cycles in which any one investment style dominates seem to have shortened. "It's difficult to play the switching back and forth between growth and value because of the more compressed time frames when these things are happening," says Jim Floyd, a senior analyst at the Leuthold Group. Floyd thinks there's a pretty good chance growth stocks could take the helm again and, indeed, they showed signs of a comeback in April.

Why Index Now?

Even if value doesn't continue to outperform, though, indexing is a savvy way to invest for the value component of your portfolio. "It makes a world of sense to index in the value arena," says

Morningstar

analyst Scott Cooley. That's true for the same reason it makes sense to index anything: The ultralow cost of index funds helps them to outperform over time. "When you index any part of the market, you're owning the same stocks as a lot of other investors, but at lower cost," says Cooley.

The cheap entry price for index funds has even more appeal lately. Given that many funds have either lost money or posted middling returns this year, investors are putting a premium on keeping expenses down. Year to date, according to

Financial Research Corp.

, three of the 10 top-selling funds are index funds: at No. 4, the

(VTSMX) - Get Report

Vanguard Total Stock Market Index; at No. 6, the

(VBMFX) - Get Report

Vanguard Total Bond Market Index; and at No. 10, the

(VFINX) - Get Report

Vanguard 500 Index.

Giving Growth a Run for Its Money
After being outperformed by growth stocks for five years, value stocks took the lead starting last year

Source: Ibbotson Associates

Surprisingly, despite all the press devoted to index investing, there aren't that many options focused on value stocks -- currently, only two retail funds focus on value indices and six exchange-traded funds. For the past decade or so, the S&P 500 has been pretty much the only show in town for index investors. While the second-place index, the Wilshire 5000, draws on a much bigger pool of stocks, it still gets three-quarters of its

market cap from S&P 500 stocks. The value component there isn't too big, either.

But the dearth of value indices doesn't mean value indexing is a bad idea; it simply reflects the popularity of growth investing throughout the '90s. That's likely to change as fund companies jump on the

value bandwagon. "Fund companies chase performance just like individual investors," says Cooley. "I'd be really surprised if we didn't see more value index funds rolled out." Around 35 value funds have debuted in just the past six months, though no value index funds were introduced in that period.

Your Options

While there aren't yet any value indices based on the Wilshire 5000, one good choice for now is the

(VIVAX) - Get Report

Vanguard Value Index. Based on the

S&P 500/Barra Value Index

, which contains the stocks in the S&P 500 with the lowest

price-to-book ratios, it charges ultralow operating expenses of 0.22%, compared with 0.79% for the average index fund and 1.44% for the average domestic stock fund, according to Morningstar.

Currently, the fund is overweighted in financials and energy, with little exposure to tech and health care names.

As size goes, Vanguard Value, with $5.1 billion in assets, including all share classes, is much smaller than its gigantic sibling, the Vanguard 500 Index fund, the industry titan with $92.6 billion in assets. Nor could it be called a hot seller, ranking 61st in fund sales year to date, according to Financial Research Corp. But it offers a neat diversification play for indexers: While Vanguard 500 finished down 9.1% last year, Value managed a 6.1% gain. Year to date, it's beating the Vanguard 500 by several percentage points again.

Vanguard Value's top-10 lineup includes names like

Philip Morris

(MO) - Get Report

,

Bank of America

(BAC) - Get Report

and

AT&T

(T) - Get Report

, all of which have posted about 20% returns, or more, for the year to date. The fund also boasts an unexpectedly strong performance record, despite the domination of growth in the late '90s. The fund racked up a five-year annualized return of just less than 15%, or only 0.22% less than the S&P 500 for the same period, and ranks in the top 22% of large-cap value funds over that time. (It isn't old enough to have a 10-year record.)

Another value indexing option is the 2-year-old

(VISVX) - Get Report

Vanguard Small-Cap Value Index, based on the

S&P Small Cap 600/Barra Value

index.

Barclays

also offers several exchange-traded funds based on Barra Value indices, including

(IJS) - Get Report

S&P Smallcap 600/Barra Value Index, the

(IJJ) - Get Report

S&P Midcap 400/Barra Value Index,

(IVE) - Get Report

S&P 500/Barra Value Index,

(IWW)

Russell 3000 Value Index,

(IWN) - Get Report

Russell 2000 Value Index and

(IWD) - Get Report

Russell 1000 Value Index. (Unlike mutual funds, ETFs trade like stocks throughout the day. Because they must be bought or sold through a broker, though, they tend to work best for investing lump sums of money.

No-load mutual funds may offer a better deal for those who want to invest sums of money over a period of time.)

While it's possible to use a value play like Vanguard Value as a core holding for your portfolio, if you're an index junkie, it's hard to beat something as comprehensive as the Vanguard Total Stock Market fund. It probably makes more sense, then, to use a value index to offset growth-oriented equity funds you already own.

Remember, relative to actively managed funds, index funds typically don't shoot the lights out. A number of actively managed value funds, for example, have amassed sexier performance records than 9-year-old Vanguard Value, the most popular value index. (See this

column for a list of favorites from

TSC's

Ian McDonald

.) But then again, you don't buy index funds expecting loop-de-loop returns; you buy them because they're cheaper and have less performance volatility than their actively managed counterparts. And that means they tend to be among the top performers -- if not always the best -- over the long run.