Dear Dagen: Is This the Wrong Time for an S&P 500 Index Fund?

A broker tries to steer a reader away from the Vanguard 500 Index.
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I'm getting mixed messages from books, information on the Internet and my broker's comments concerning index funds. I told him I wanted to take my funds out of my Goldman Sachs and Delaware funds and invest in the (VFINX) - Get Report Vanguard 500 Index fund. My broker tells me the Vanguard 500 Index fund is not one he would recommend. He told me today that only a few of the 500 stocks are doing well, and therefore these stocks are carrying the entire fund. I'm confused. -- Ruth Mangione

Ruth,

Your broker is right about the influence of a few enormous stocks on the

S&P 500's

performance. However, that shouldn't necessarily dissuade you from investing at least some of your money in an index fund.

The S&P 500 is what's called a market-capitalization-weighted index. That means bigger companies have a greater effect on the index's performance than smaller companies. In 1998, for example, the largest 100 stocks made up 66% of the index's weight but contributed 85% of the index's return, according to research from

Morgan Stanley Dean Witter

. That means the remaining 400 stocks in the index provided only 15% of the index's return.

Microsoft

(MSFT) - Get Report

alone contributed 8% of the S&P's performance during 1998, according to Morgan Stanley's research.

This phenomenon is what market commentators and their ilk refer to as a "narrow market."

Under these conditions, it's extremely difficult for active fund managers to keep up with the index if they don't own this small group of dominant stocks. Indeed, during 1998, only 17% of actively managed general equity funds were able to beat the S&P 500, according to

Lipper

.

This top-heavy market continued to hold sway during the first quarter of this year. But during the second quarter, the market "broadened," as small-cap stocks produced some strong returns. The smallest 100 stocks in the S&P rose an amazing 26.5% during the quarter, according to Morgan Stanley research.

And when the market widens to favor stocks other than the biggest ones, active managers have a better chance of beating the index because a broader range of stocks are doing better.

But the market has again narrowed during the third quarter with gigantic technology names like Microsoft and

Cisco

(CSCO) - Get Report

driving performance, according to Leah Modigliani, U.S. strategist at Morgan Stanley.

And the index continues to dominate active managers. Through Sept. 9, just 36.1% of actively managed general equity funds were outperforming the index this year, according to Lipper.

I don't know the types of funds you own, but I can understand why your broker would steer you away from an S&P 500 index fund. If the giant stocks that dominate the index stumble badly, the index will fall harder than other funds that are less reliant on these large names.

Perhaps you don't want to pour everything you own into this one fund, but this doesn't mean that you should shun index funds altogether.

First, the S&P 500 index has a pretty good track record against active managers. Since 1970, a majority of actively managed general equity funds beat the index in only 10 out of 29 years. Plus, you have to consider whether you and your broker can consistently pick active managers who can consistently beat the index. As a believer in the efficient-market theory, I would venture to say that it's pretty hard, if not impossible, to do that year-in and year-out.

Secondly, the Vanguard 500 Index fund is a low-cost, economical way to get diversification via one portfolio. Sure, it's led by large stocks. However, the market-weighted index is constructed to allow fast-growing companies to rise to the top and carry more influence.

At the end of 1993, Microsoft wasn't even one of the 10 largest companies in the S&P 500, but at the end of 1998, it was the biggest.

Chances are that the index's current leaders won't always lead the pack. But can your broker or an active fund manager accurately predict which stocks will be the new leaders?

Rather than putting everything into an S&P 500 index, you could allocate just some of your money to this index. Or you could try a fund that tracks the

Wilshire 5000

index, which includes more small- and mid-cap stocks, and offers even broader diversification.

John Markese, president of the

American Association of Individual Investors

, suggests putting 50% in an S&P 500 fund and using active managers for the rest of your portfolio. (See a previous

Dear Dagen about finding the right mix of actively managed and index funds.)

If you are sold on index funds, you can find ones that track small-cap and international benchmarks as well. By putting maybe 25% of your equity allocation in both small-cap and international, you will at least diversify your portfolio away from the large-caps in the S&P 500, says Bryan Olson, research director at the

Charles Schwab Center for Investment Research

.

While your broker is right about the S&P 500 index, you should remind yourself that he's a broker who more than likely gets paid on commission. He might not be too anxious to put you in no-load funds like those at Vanguard.

Before you take anyone's advice, you should always take a close look at the messenger.

Nyet Returns

I watched a fair amount of the

U.S. Open

tennis tournament and caught

Charles Schwab's

commercial featuring nubile tennis star

Anna Kournikova

reciting a litany of investment terms.

It was an amusing idea the first time I saw it. After the fifth time, I got tired hearing her explain P/E.

Then again, I would be a disaster trying to explain the efficient-market theory on Russian TV.

Dear Dagen aims to provide general fund information. Under no circumstances does the information in this column represent a recommendation to buy or sell funds or other securities.