Index Fund Popularity Waning? By John Spence February 28, 2001

"One of the most popular investment products of the 1990s - passively managed index funds that mimic the movements of major market indices - may have reached a peak in their popularity," says a new report by Eaton Vance, a Boston-based investment management firm.

How popular is index investing?

As of June 30, 2000, U.S. institutional tax-exempt investors had $1.68 trillion in domestic and global indexed assets, according to recent research by Barclays Global Investors (BGI).

Continental European managers had in excess of $90 billion in European indexed assets as of June 30, 1999. Greenwich Associates recently released a report that the percentage of Continental European assets that are indexed will jump from the current 12% to 16% by 2003.

Exchange-traded funds, which track indexes and can be traded like stocks, have also taken off in popularity and attracted over $60 billion in North America, according to BGI.

Investor Attitudes on Index Funds

Eaton Vance conducted a national telephone survey of 500 Americans who have invested in both qualified retirement plans and other investments such as mutual funds, individual stocks, or money market funds. The median annual income of respondents was $100,000.

Survey participants were asked whether they would likely invest in index funds in the next couple years. A majority (51%) said they are less likely to invest in index funds, 29% said they would be more likely to, and 20% said the same or didn't respond.

Among investors who indicated they were less likely to purchase index funds, the most popular reason (31%) was higher market volatility.

"Data from the survey supports Eaton Vance's view that we are past the peak of popularity for passive investing," said Duncan W. Richardson, manager of the Eaton Vance Tax-Managed Growth Fund. "The year 2000 partially exposed the fatal flaw of indexing - the fact that indices are constructed without applying any valuation discipline or investment judgment. In the results of 2000, investors experienced the risks of this approach and are now beginning to vote with their feet."

The survey also painted a bleak picture of investor understanding of how market indexes are created and maintained. Nearly half of survey respondents (44%) believe, incorrectly, that stocks in Standard & Poor's (S&P's) indexes are selected on the basis of their investment merits or attractiveness of their valuations. In contrast, 24% gave the correct response: stocks are selected that make the index more representative of the broad US economy.

How do Index Funds Fare During Volatile and Bear Markets?

The main reason identified by survey investors for why they would not purchase index funds was higher market volatility. This could perhaps be a result of the misconception that index funds have greater standard deviations than actively managed funds and therefore carry higher risk. In his latest book, What Wall Street Doesn't Want You To Know, Larry Swedroe thoroughly debunks this market myth.

According to Swedroe, actively managed funds do have lower volatility because they tend to carry significant cash positions due to their market timing and stock selection strategies, while index funds are always fully invested in equities. Although Swedroe doesn't suggest ignoring volatility, he says it's not something an investor can spend.

"The fully invested position of index funds is one of the main reasons index funds outperform actively managed ones," says Swedroe. Of course, lower management fees and turnover combined with increased tax efficiency are also significant factors.

There is also a common belief that passive funds that have high index correlation do well in rising markets, but suffer when the market is falling. Again, the active manager's advantage is that he or she has cash reserves averaging about 10% of assets. Swedroe cites a study by Lipper Analytical Services that examined 6 bear markets (defined as a drop of at least 10%) from August 31, 1978, through October 11, 1990. The average loss for the S&P 500 was 15.12%, while the average loss for large-cap growth funds was 17.04%. The Vanguard S&P 500 Index fund charges an expense ratio of 0.18%, but active funds still underperformed by almost 2% per year.

Furthermore, Swedroe points out that during the bear market of the third quarter of 1998, the S&P 500 fell 10.1%, while the average fund fell 11.7%.

Swedroe quotes Susan Dziubinski of Morningstar to sum it up: "The average fund can't keep up with its index when it's sunny or when it's rainy."