Index Funds With Some Real Oomph

Barclays Global plans to add 36 exchange-traded index funds over the next two months.
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Many investors who have grown weary of mutual funds have been pouring money into the new index products on the

Nasdaq

and

American

stock exchanges over the past year.

The indexing trend is likely to accelerate as

Barclays Global Investors

, the largest institutional index manager in the world, brings to market 36 new index-based exchange funds over the next two months.

Indexing isn't sexy and doesn't offer the excitement of investing in individual stocks. But it does offer a solid investment strategy at a relatively low cost that all investors -- beginner or advanced -- should consider for at least part of their portfolios. That is why this is important and why you, as an investor, should care.

Other institutional managers are watching Barclays closely and are likely to jump on board with their own products. "It would be arrogant for us to say we're going to overtake the fund industry," says Tom Taggart, a spokesman for Barclays. "We're not. But maybe this is the new 'new thing' in funds."

New Funds Offer Many Advantages

Maybe. These index-based investments -- called exchange-traded funds -- offer a number of advantages over the open-ended mutual funds that are sold by fund companies. Whereas traditional funds are priced at the end of the trading day, exchange-traded funds are priced constantly throughout the day.

They can be traded throughout the day, sold short (which means borrowing the securities and selling them with hopes of buying them back at a lower price to pay back the loan), bought on margin (which means borrowing the money to buy them) and bought and sold with limit orders (which means setting a price for the transaction in advance). Many of the aforementioned techniques are not ones I would advocate for beginning investors, but index-based funds are great buy-and-hold investments as well.

Exchange-traded funds, which blend the characteristics of mutual funds, closed-end funds and stocks, also offer low turnover and some tax efficiencies over traditional mutual funds. Expenses are low, too, typically around one-fifth of 1% (or 20 basis points), compared with an average of 1.45% for mutual funds.

Strong Reasons for Indexing

Thanks to John Bogle, founder and former chairman of the

Vanguard Group

family of funds, educated investors know the advantages of indexing. "John Bogle made a powerful case for indexing in the retail market just like we did in the institutional market," Taggart says. "It is perfectly OK to explore the hot funds on the periphery once you have this core position."

The exchange-traded funds deliver expenses in the same low range as the Vanguard funds. They have no front-end loads, back-end loads or redemption fees. You must pay a brokerage commission to buy one, though.

Barclays is the largest institutional money manager in the world, with $780 billion under management. Barclays introduced investors to indexing 25 years ago, and it remains the largest index manager in the world.

The 30 indices already on the Nasdaq/Amex include the

Standard & Poor's Depositary Receipts

(SPY) - Get Report

, or SPDRs, (pronounced spiders), which track the

S&P 500

index; the

Nasdaq 100

tracking stock

(QQQ) - Get Report

, which tracks the 100 top Nasdaq stocks; several sector S&P indices; and the

World Equity Benchmarks

(WEBs), which invest in 17 different countries. Assets in these products totaled $34.4 billion the first week in February, according to Gary Gastineau, who heads research and development for index products at the Nasdaq.

The new indices, which include 14

Dow Jones

sector indices as well as several S&P small-cap and foreign indices and eight

Russell

indices, will all be introduced as open-ended mutual funds rather than unit investment trusts, Taggart says.

Mutual Funds vs. Trusts

This brings up an interesting point about some of the indices trading on the Nasdaq, such as the Nasdaq 100 and SPDRs. Those are set up as unit investment trusts (UITs), which I discussed in a

past column.

The others, including the S&P sector indices and the 17 WEBs, are set up as open-ended mutual funds. There are two important distinctions that investors need to understand between these two investment vehicles.

First, UITs cannot reinvest dividends immediately upon receipt. The dividends are held in an interest-bearing account and invested at the end of the quarter. Bogle pointed to this disadvantage to SPDRs in a

recent interview. That lag is called "cash drag," because it adversely affects the total return of the product.

The second difference is that mutual funds have boards of directors to look out for shareholders' interests. Now you can argue -- as I have in the past -- that the boards are stretched too thin and don't always look at issues as closely as we'd like, but there is at least some independent oversight.

Some Room for Strategy

There's another wrinkle here, too. In a mutual fund, a manager has more flexibility and discretion over how to manage the money. With a UIT, the trustee has no discretion whatsoever. Because there is no board to represent investors, the manager is instructed to buy a specific list of securities -- and that's it.

At first blush, it might seem that that's not so important for indices. But it can be. A UIT that invests in an index must buy every single security in that index, even if there are 3,000 of them. But a mutual fund can use a technique known as sampling, which involves buying a sample of the securities that represent the index. Although buying all the stocks is purer in a sense, it may not actually be better. That's because it's difficult and costly to buy small, illiquid stocks. So this difference could be important, and it is one for investors to mull over.

Barclays' Big Plans

Barclays will offer two versions of the S&P 500: the

S&P 500/BARRA Growth

index and the

S&P 500/BARRA Value

index. It will be interesting to see if savvy investors switch their loyalty from the SPDRs, which have been trading since 1993 as UITs, to the new Barclays indices, which will trade as open-end funds. "I've heard rumors that the folks who are running SPDRs will probably restructure to a fund because the UIT is at a clear disadvantage," Taggart says.

Barclays plans 51 index funds this year, the first 36 to be introduced in March. In addition to the two S&P 500 funds, they include an S&P 100; the

Russell 3000

;

Russell 2000

and

Russell 1000

, with each split into Growth and Value components as well; the

S&P Midcap

and

S&P SmallCap

, with their value and growth components;

S&P Europe

;

S&P Toronto

; and these Dow U.S. sector funds: Basic Materials, Consumer Cyclicals, Consumer Noncyclicals, Financials, Healthcare, Industrials, Technology, Telecommunications, Utilities, Chemicals, Financial Services, Internet and Real Estate.

The Dow sector indices offer an interesting little twist as well for investors. Investors who like sector funds will want to take note of the difference between the nine S&P 500 sector indices already on the market and the various Dow Jones indices that will be introduced by Barclays. Because the S&P sectors are made up of the 500 stocks, all the sectors represent investments in big-cap stocks, those large companies that make up that index. Not so with the Dow sectors, which are based on the total market. So an investment in, say, the Dow Jones technology sector represents large-, mid- and small-cap stocks. It will be interesting to see how these two indices compare.

Taggart will not provide details about the funds because they are still in registration. But the complete prospectus is available at

FreeEDGAR. Expenses are not included.

I will be watching closely, too. This gives me the best chance I've seen in a long time to fill in some holes in my own portfolio.

Mary Rowland is the Start Investing columnist for MSN MoneyCentral. At time of publication, she was long Cisco Systems, Intel, Microsoft, Qualcomm, JDS Uniphase, TranSwitch, Enron and Vitesse Semiconductor, although holdings can change at any time. Under no circumstances does the information in this column represent a recommendation to buy or sell stocks. She welcomes your feedback at

mctsc@microsoft.com.

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