Latest Indexing Idea: Top Picks of Investment Clubs

Returns for the Individual Investor's Top 100 Index are impressive, but investment clubs usually don't beat the market.
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You could call it the people's index. Its real name is the

Individual Investor's Top 100 Index

, and it tracks the stocks most popular with investment clubs.

The index was introduced with little fanfare in December by the

National Association of Investors Corp.

-- you know, the investment-club folks known for their most famous members, the

Beardstown Ladies

(or should I say infamous, since the ladies' supposedly stellar returns turned out to lag the market).

Though the index is new, the top-100 idea has been around for a while. Here's how it works: The NAIC surveys its members in November, asking what their top holdings are. Last year, nearly 34,000 surveys went out, and the NAIC got responses from 16% of recipients. From survey results, the NAIC extrapolates holdings of all 37,000 clubs, some 700,000 members strong. The new top-100 list comes out in April, so the index now reflects the survey taken in 1997.

That may sound like ancient information, but in any given year, there are usually only one or two changes to the list, and seldom more than six or seven, says NAIC President Ken Janke. Anyway, NAIC isn't interested in publishing an index that mirrors the daily hoo-hah on Wall Street. The people's index will be updated monthly, thank you, in keeping with the group's policy of ignoring day-to-day fluctuations in the market. (Check

here for monthly results.) Like the

Dow

and the

S&P

, the index is market-weighted -- each stock influences the index in proportion to its value and to the number of shares in club portfolios.

With indexing all the rage these days, it's not surprising that yet another one is vying for our attention.

Wired

magazine introduced its

21st Century Information Economy Index

in June, and by December,

Guinness Flight

had trotted out a fund to track it. (See our previous

story.) Could the same thing happen with the top-100 index? And would it be worth looking at?

The official answer: The group hasn't discussed it with anyone, says Janke. But he is open to the possibility. And why the heck not? Returns on the index look pretty decent. NAIC back-tested the index 10 years and found that the top 100 delivered an average 21.5% annual return, beating both the S&P (up 19.2%) and the Dow (up 18.8%). Last year, the top 100 kicked you-know-what, returning 44.4%, compared with 28.4% for the S&P and 17.7% for the Dow.

The octane is coming from more than a couple of big engines. A look at the top 10 of the top 100 finds six that trounced the S&P over the past five years and a seventh,

McDonald's

(MCD) - Get Report

, in a virtual dead heat. (

Tricon

(YUM) - Get Report

and

Lucent

(LU)

haven't been around for five years.)

Over 10 years, all but

Diebold

(DBD) - Get Report

beat the S&P.

Source: NAIC, Baseline. *Since September 1997. **Since April 1996.

The rest of the list includes many of the big names you'd expect to see:

Disney

(DIS) - Get Report

,

Microsoft

(MSFT) - Get Report

,

Gillette

(G) - Get Report

and

Procter & Gamble

(PG) - Get Report

. (The NAIC Web site has the

full list.)

But as Jim Atkinson, the Guinness honcho responsible for setting up the Wired Index fund, pointed out, there are some lesser-knowns as well, like No. 13

RPM

(RPM) - Get Report

, a manufacturer of protective coatings, and No. 88

Pall

(PLL) - Get Report

, a maker of filtration products. "The list intrigued me. It wasn't all household names," he says.

Atkinson won't be bidding on the license for the top 100, but he wouldn't be surprised if someone else did. He's even got a marketing angle in mind: "This is a way to invest away from Wall Street," he says. "It's Main Street vs. Wall Street. It's a pretty good idea for a fund company."

Maybe so, but there's a big difference between a good marketing concept and a good investment. I probably would avoid investing in the top-100 index, and here's why:

Investment clubs, as a rule, don't even come close to beating the market -- or the typical individual investor, for that matter. This I know courtesy of Terry Odean, a finance professor at the Graduate School of Management at the

University of California at Davis

.

Odean tells me that between 1991 and 1997, investment clubs he studied -- using trading records at a large discount broker -- returned just 14.1% a year. That was 3.7 percentage points less than the market and 2.3 percentage points less than individual investors, on average. Fully 60% of the clubs he studies lagged the market.

Where'd they go wrong? A penchant for small, high-risk growth stocks, costly trading and too much of it, apparently. Worst of all, the stocks the clubs bought typically returned 4.2 percentage points below the ones they dumped to buy 'em.

So why does the top 100 look so good? Odean speculates that there's some selection bias at work. The winning clubs are more likely to respond to the NAIC's survey each year. Maybe those clubs are full of truly gifted stock pickers. Or maybe they were just holding the issues that came up "heads" that year. Either way, says my finance professor friend, "Based on the one piece of research I've done, I can safely say I won't be the first one buying into an index based on what investment clubs hold."

Nor would anyone buying into a top-100 fund be a true index investor. You wouldn't be passively buying the market or even a market segment, then going along for a random walk. Uh-uh. You'd be placing a definite bet. Buying this index, whether a fund company licenses it or not, is like buying any mutual fund -- with low turnover, maybe, but an actively managed fund just the same.

Look at it this way, says Odean: "It's like buying a mutual fund with 100,000 managers."

Now that's a scary thought.

Anne Kates Smith is a senior editor at U.S. News & World Report in Washington.