Indexing Ain't So Easy After All
Choosing index funds is often called passive investing, but it's only passive for the portfolio manager. Investors who think they can dump their actively managed funds and "just buy an index fund" are in for a surprise. There are all kinds of indexes out there and a remarkable variety of index funds.
You might think I'm going to expound on the disparity between the returns of large-cap indexes and small-cap indexes. Nope. That's old news. I'm talking about the difference between index funds ostensibly tracking the same thing, such as plain old blue chips. Do you choose a fund that mimics the Dow Jones Industrial Average or one that follows the S&P 500? It's not an idle question. If you simply pick the most well-known index fund--Vanguard 500 Index VFINX--that's still a deliberate choice. So far this year, the S&P 500, with a 10.9% gain, lags far behind the DJIA's 18% climb. Last year, the places were reversed. So which index do you want to track?
And that's just large cap vs. large cap. Wait 'til you try to select funds that attempt to track foreign indexes and small-cap indexes. In those realms, there's even less agreement on the proper index to follow. (Note that the Russell 2000, one small-cap index, is up about 3% this year, while another, the S&P 600 SmallCap, is down 3%.) And some small stocks and foreign issues don't trade much, so it can be harder for a fund to faithfully match indexes in those areas.
Welcome to actively managing your passively managed funds.
Kosovo--Closer Than You Think?
A Zurich-based portfolio manager I recently interviewed said that European managers' key worry right now, ahead of economic slowdowns or the euro's slide, is Kosovo. Even though I follow foreign news with interest and have been paying attention to the Balkan troubles for years, apparently I had subconsciously relegated the NATO bombing campaign to the category of "something happening far away." For a manager in Switzerland, the opposite is true: When I expressed surprise that the Kosovo situation would affect stock-market decisions, he said simply, "It's an hour from Zurich." Among other things, he said, the prospect of waves of refugees streaming into European countries raised concerns about political and economic disruption.
In the long run, it doesn't pay to base investment decisions on politics, wars, health scares, or other such factors, because the ultimate driver of stock-market performance is company earnings. But when a manager much closer to a crisis area than I am says the crisis is affecting the markets, I figure it's worth listening. In the short term at least, events in Kosovo could have more influence on European-stock prices than most Americans might expect.
Monitoring the Money Managers
Some folks, no doubt, are tired of hearing us at Morningstar (and officials at the SEC) rail about how fund directors should do a better job. You can't really expect directors to fire advisors left and right, can you? How would that work? Wouldn't it be chaotic--and overly subjective?
As it turns out, the model is right in front of our eyes. While directors fire advisors only in the rarest of circumstances, it's not at all uncommon for advisors to fire their subadvisors. It happened a few days ago at Smith Barney Premium Total Return SOPTX. The fund's advisor--a former Smith Barney unit now known as SSB Citi Asset Management--had hired Boston Partners to run the fund. Performance has been lousy. So Boston Partners is out, and an in-house team will try to provide a spark.
Indeed, subadvisors often get replaced. Vanguard, which farms out the management duties on many of its funds, provides the most prominent examples, but it is far from unique. Mitchell Hutchins, advisor of PaineWebber Global Equity KPGEX, dumped subadvisor G.E. Investment Management last autumn after a string of subpar years. John Hancock Special Equities JHNSX finally severed its relationship with Michael DiCarlo's firm in mid-1998.
When an advisor (whose name is likely to be on the fund) pays another management firm to run the assets, it expects results. If it determines it can get better results elsewhere, it waves goodbye. In many ways, all we're asking is for directors to apply that same standard to the fund advisors. If the directors keep an eye on fees, too--well, then we'd be halfway to mutual-fund utopia.
Stat du Jour
The number of index funds in Morningstar's database: 168.
Indexing Ain't So Easy After All