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The Hidden Drawback of Indexing

Index funds are in effect momentum players.

Gregg Wolper, 02/21/2006

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There's no doubt. Index funds have a lot of advantages. Traits such as low costs and tax efficiency get plenty of attention from Morningstar and the financial media. The disadvantages of using an index strategy, however, receive far less notice.

Index funds aren't perfect, and this is an opportune time to remind everyone of that. After all, a torrent of money has poured into exchange-traded funds--all of which, so far, are essentially index trackers. One such fund, iShares MSCI EAFE Index EFA, garnered more inflows in 2005 than nearly any other fund of any type. It now has an astounding $24 billion in assets.

It's worth remembering, therefore, the main drawback of index funds: Such funds tend to put more of their money into stocks (or sectors, or countries) that are rallying. And there's no stopping that trend: The manager's job is to match the index's construction, not to question it. So when such funds receive inflows, the manager must buy more and more of the hottest stocks (or bonds), chasing them higher and higher and higher, no matter how expensive they get. Even without inflows, the weighting of those securities becomes greater and greater, because their market values are soaring while those of other portfolio holdings are either rising less rapidly, stagnating, or falling.

This trait obviously hasn't stopped index funds from being strong relative performers, and solid choices, in many situations. However, as with the tendency of fair-value pricing to render international-index tracking less exact than you might think, every investor should fully understand this trait, if for no other reason than to avoid unpleasant surprises.

Japan's Rise and Fall--and Rise

An example of what might be called "weighting creep" is occurring right now in the funds that track the most well-known foreign-stock benchmark--the MSCI EAFE (Europe, Australasia, Far East) Index. The story begins in the 1980s, when Japan's market went on an incredible run, and its share of the EAFE Index consequently grew and grew. By 1989, the peak of Japan's rally, that market made up more than 40% of EAFE--and thus of any fund portfolio that tracked that index.

Then, Japan's market crashed, and as its economy endured a lengthy period of sluggishness, the market went through an interminably long bear stretch broken only by a few futile rallies. Other countries' markets, meanwhile, were performing much better. By September 1998, Japan's EAFE weighting had tumbled to roughly 20.5%.

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