Managing an Index Fund Isn't Monkey Business

It takes a lot of activity to run these 'passively' managed funds.
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Regis Philbin

probably wouldn't even put the question in

Who Wants To Be a Millionaire's

wimpy $100 category: Name the manager of your index fund.

    A computer
    A monkey
    A guy named Gus

Easy, huh? Everyone knows those passive investments require little more than a decent computer program to make them tick. Heck, for stale indices such as the

Dow Jones Industrial Average

and the

S&P 500

, which rarely invite new members, it doesn't even have to be a high-speed one. Since index funds merely mirror a set list of stocks, no stock-picking is involved. Just spit out the weighting of each stock and rebalance accordingly. That's work for a computer, or as many active managers snicker, a monkey.

Hold on a second -- that better not be your final answer.

The truth is, if left to chimp or computer alone, an index fund would deliver less to you. A smart professional is quite simply required.

A look at the numbers shows that not all index funds are created equal. According to

Morningstar

, the average annual return of S&P 500 funds over the past five years can vary dramatically -- the cellar dweller offered 24% and the top performer racked up 28%. Naturally, a lot of that can be attributed to different expenses. If that were the only difference, the lowest performer should charge the most. But that's not the case. And even among the S&P 500 funds whose annual expense ratios are the same, results differ.

But the question remains: Exactly how do index managers make a difference? Given that they don't do what most active pros spend most of their time doing -- picking stocks -- how do these guys earn their keep?

A trip to the best in the business answers that question. At the headquarters of the

Vanguard Group

in Valley Forge, Pa., I spent a busy morning with Gus Sauter, who is in charge of the industry leader, the $100 billion

(VFINX) - Get Report

Vanguard 500 Index. (I purposefully chose a typical day last week, before the entry of

Yahoo!

(YHOO)

into the S&P 500, which would obviously be a crazy day for all index managers as they try to buy millions of shares of the highflier.)

It doesn't take long to figure out that Sauter and his trading team don't sit with their feet up watching busy banks of computers do the heavy lifting. If they did, they might be out of a lot of money.

First off, the index providers -- the companies that update managers daily on the weightings of the stocks in the index -- aren't always accurate. Sometimes there's an error in shares outstanding. And often, those can be big errors -- we're talking about an extra zero. "So all of a sudden you think a $200 million company is a $2 billion company, and the software tells you to buy the stock like mad," Sauter explains.

He remembers the time that computer-generated lists recorded a $2 million company that manufactured baseball scoreboards as a $2 billion stock. The computer said buy, and big time. If Sauter and colleagues had traded everything electronically, they would have tried to buy more BASBL than existed. That would have meant pushing the stock through the roof before realizing they'd have to sell it -- and at huge losses. That kind of mistake would have meant millions of lost money for shareholders.

Sure, you counter, it's clear in any business that computers need supervision. But that's not a full-time job, right?

No, but managing an index fund is much more than that. Index managers add value in two key ways:

Carrying the cash.

In a bull market like this one, carrying cash carries a price. Actively putting new investment money to work is critical. For S&P 500 funds, which haul in fresh money by the truckload, that's especially true. The Vanguard 500 Index is a magnet for $100 million a

day

. It even had positive cash flow in August of last year, when most mutual funds were hit hard with redemptions. Waiting until the end of the day to put that in the market could on average be a big drag. "If you let it sit on the sidelines for a day, that could hurt," Sauter says.

His team of traders is constantly investing throughout the day, looking for the best price and the most efficient trade. They use a variety of methods, but rely heavily on alternative trading systems, such as ECNs, to lower transaction costs and boost portfolio performance.

Trading strategy.

Yes, index managers have to mirror their market, so they're not choosing stocks. But

how

they buy those stocks can add or subtract from performance. At Vanguard, traders such as Michael Buek use futures constantly in the search for cheaper prices. "To the extent there's a discount, that discount is true value-added to the fund," Sauter adds, describing Vanguard as among the more aggressive index users of this strategy.

Of course, the manager doesn't get all the credit or blame for an index fund's performance. The fund family has a lot to do with that -- namely, in the expenses it charges. By keeping costs low, shareholders enjoy more of an index's gains. Also, the firm's redemption policy can have an impact. By discouraging active traders, managers can count on more consistent inflows, which affect turnover and taxes. Vanguard screens all big investments for time horizon and turns away active traders anxious to jump in and out of their funds.

So maybe the name-the-manager question is harder than it appears. And even though the myth persists that this job doesn't take much smarts, index managers deserve more respect. A plaque hidden near the back of Sauter's office could serve to remind him of that, and in the most measurable way possible. It's a bar graph showing how he grew the level of indexed assets under management. Under his watch, they jumped to well over $200 billion today from $1.2 billion in 1987.

The inscription? "No, a monkey couldn't have managed that."

Brenda Buttner's column, Under the Hood, appears Thursdays. At time of publication, Buttner held no positions in any securities mentioned in this column, although holdings can change at any time. Under no circumstances does the information in this column represent a recommendation to buy or sell stocks or funds. While she cannot provide investment advice or recommendations, Buttner appreciates your feedback at

TSCBrenda@aol.com.