Interview with Morningstar's Peter Di Teresa By John Spence December 10, 2002

Peter Di Teresa is a consultant at Chicago-based Morningstar, Inc. Before moving on to a new role within Morningstar, he wrote the "Ask the Professor" column that frequently addressed issues concerning index investing.

Q: Total stock market (TSM) index funds have been marketed as an easy, cheap, low-maintenance choice for equities in a portfolio. How have investors reacted with those funds down a lot since 2000?

A: TSM funds are a good option for people looking for diversified, one-stop U.S. market exposure. That's the main attraction. The tradeoff is that you have to go with what the market looks like, since the index is market capitalization-weighted. So you're going to get the small-cap allocation that reflects the overall market.

Vanguard never sold its TSM fund as something that provides asset class diversification. It is possible that investors didn't do their homework and therefore didn't understand what they were getting with a total stock market fund. But there's not much Vanguard can do to fix that. It's the same with any investment - you have to know what you're buying; it's your responsibility as an investor.

Even for those who did do their homework, the thing that may have surprised people was how much total stock market funds lost in the bear market. The same probably applies to S&P 500 funds, which also took a beating. Maybe people didn't necessarily expect how vulnerable these funds can be. Even though TSM funds are diversified in a lot of ways, they're also entirely exposed to the U.S. market. In particular these funds have a lot of large-cap stocks, and when large caps are out of favor - as they have been - that can potentially spell a lot of trouble.

I would note that it doesn't look like the Vanguard Total Stock Market fund was hit with massive redemptions. That seems to suggest at least that people knew what they were getting, and they weren't shocked enough to get out of the fund.

Q: Are investors making a mistake piling into bond funds as they are now?

A: It's probably not as dangerous or risky, but the problem is comparable with what happened in the late 1990s with investors piling into stock funds because they were doing so well. Regarding the current situation with bond funds, the warning signs are even more ominous. Stocks have been down for a while, and are becoming more attractive. At the same time, bonds have benefited from all the cuts in interest rates. There's not a lot of room to bring rates down from here, although who knows what the future holds. But in that situation, bond funds that have benefited from the falling rates are going to get hit and could post losses. Again, it's nothing on the scale of the losses you would expect from an equity fund, but I think people are going overboard with bond funds now.

There's also issue of going overboard from an asset allocation perspective. People jumped into stocks in the 1990s and now they're jumping into bonds. You need to have a mix of the two.

It doesn't seem like a great time to be piling into bonds this late in the bear market. Clearly there are a lot of investors who have done a poor job of timing their asset allocation moves, at least historically.

Q: What's the biggest challenge for index fund providers?

A: Broadening the market. The vast majority of index funds, to this day, still track the S&P 500, and that's where most of the assets are. After the bear market, we now know that the S&P 500 by itself in a portfolio isn't enough. You need greater diversification across market capitalizations and across asset classes. So one challenge is getting investors to look at other kinds of index funds. I think that's also going to be important from a business standpoint, because the market for S&P 500 index funds is mature, so the demand isn't as strong anymore.

However, there could be demand in the future for index funds that track other asset classes. For example, indexing is a particularly powerful strategy in the bond world. For buy-and-hold investors, bond ETFs could be appealing because the commissions become less of a factor.

Q: Vanguard is considering switching benchmarks for some of its index funds. How has this changed the outlook for index providers?

A: Index providers probably took notice when the biggest retail index fund provider out there started talking about switching benchmarks. On the other hand, Vanguard's reasons for making the move are sound. In a broad sense, this will force index providers to look into ways to improve their benchmarks. The reason Vanguard is making the switch is because they believe there are indexes that better capture a particular slice of the market. That's a worthwhile endeavor. The S&P/Barra style indexes that Vanguard currently uses define growth and value in a narrow way. Only one criterion is used: price-to-book ratio. There's many other dimensions to look at and consider.

Q: Exchange-traded funds are a relatively new development in indexing. Will these new products be able to win over retail investors?

A: It looks like the main market for ETFs now is market timers. There are so many ETFs to choose from, but the activity in ETFs is very narrow. Most of the assets and trading activity are centered mainly in only two funds: the 'spiders' (SPY) and the 'cubes' (QQQ). So if ETF providers are trying to appeal to the broad investor, it's not working at this point.

ETFs have several limitations for the everyday investor. Trading commissions are a problem. To keep your cost basis down to the equivalent of an index mutual fund expense ratio, you really need to invest a significantly large amount of money. Just how much depends on your broker and how frequently you trade. But it makes no sense to dollar-cost-average with small amounts because the commissions will chew up your returns.

The appeal may be more for active traders who benefit from trading throughout the day. The other group would be high net worth individuals, where the amount they're investing is large enough that the commissions don't matter, and the tax advantages over index funds become more meaningful. ETFs are also good for precise asset allocation, and many financial planners develop asset allocation models and use ETFs to implement them.