Alternatives to S&P 500 Index Funds

The 2005 Morningstar Investment Conference was last week (June 20-22), and among the most eagerly anticipated panels among Morningstar fund analysts was "The Right Way to Index" with PIMCO's Rob Arnott and Vanguard's Gus Sauter. Yes, yes, we fund analysts are aware that eagerly awaiting a discussion of index funds, much less the methodology of indexing, puts us smack-dab in the middle of Nerdville. Maybe that's ameliorated by the fact that what we most yearned for was a healthy debate over an idea that many investors might think an accepted fact: Market-cap weighted indexes are very solid foundations for passive investments.

The iconoclast on the panel, Rob Arnott, takes issue with that notion. A simplified version of his argument follows. While a firm's market cap is to some extent based on its fundamentals, it also reflects investors' forward-looking expectations for future growth, whether positive or negative. While some will achieve expectations, others won't, and their market caps will drop. Meanwhile, many firms will overcome low forecasts and grow larger than the market expects. And in a cap-weighted index, those firms that will eventually disappoint are automatically overweighted while those that will eventually be pleasant surprises are automatically underweighted. Arnott suggests that an index that uses fundamental factors is therefore superior, and he favors a combination of normalized sales, normalized cash flow, book values, and, when available, normalized dividends. Arnott also contends that, over the long haul, such an index will deliver superior returns (which he supports with historical information); he plans to put his management where his mouth is later this summer with the debut of PIMCO Fundamental IndexPLUS fund, which will use derivatives to invest in the largest 1,000 U.S. companies using his methodology.

Gus Sauter, long the indexing guru at Vanguard, disputes Arnott's claims. He characterizes such a methodology as having a distinct small-cap and value bias, one that will cause such an index to skew from the market's returns over time. In his view, whatever flaws a market-weighted index has, it's the truest and most liquid reflection of the market, enabling the largest number of investors to use it. Moreover, he suggests Arnott's returns-based data is time-period sensitive.

It's a bit hard to judge whether the debate had a clear winner; neither manager made a slam-dunk case that overwhelmed the other. Certainly the intellectual foundation of Arnott's approach--that demonstrably faulty expectations are often baked into firms' market caps--has some merit. On the other hand, it's hard to make a clear-cut case that cap-weighted indexing is truly broken. It would take a lot of confidence in Arnott's argument to justify choosing the new PIMCO fund over, say, the  Vanguard 500 Index (VFINX). That's because, while Vanguard's offering has at most an expense ratio of 0.18% (and only 0.09% for larger accounts), the PIMCO fund's expense ratio of 0.65% for institutional shares and 0.90% for administrative shares are quite hefty for an index fund.

One takeaway from the panel, though, is that there are clearly other ways to index besides using the S&P 500 as a basis for a fund. Indeed, there's now a wealth of very attractive funds that differ from what's long been the default setting for indexing.

We can use the  Morningstar Premium Fund Screener to ferret out these other offerings. It's a fairly straightforward screen, although it does involve a couple of data points that many users might not often use.

1. "Index Funds = Yes"
It's pretty easy to find all the index funds in Morningstar's database; you simply use this line as your criterion. Finding the line can be a little counterintuitive for some, though: It is within the Special Fund Types section, which is under the General head in the Premium Fund Screener. There happen to be 482 index funds in the database. It's also worth noting that if you're making a heavy investment or desire other options, we also have an ETF screener you can use.

2. "Distinct Portfolio Only = Yes"
Click Insert next to the number of your results. Inserting the line above--which we use in almost every screen--means you only see one share class for each fund. The one you'll see has the longest record. Yes, there are occasionally different share classes for index funds.

3. "Best Fit Index not = Standard & Poors 500"
Insert this line to find those index funds that track some other index more closely than the S&P 500. Morningstar examines the correlation between each equity mutual fund and 48 indexes, and the index that's most highly correlated is a fund's "best fit" index. Bond funds are compared with each of 25 indexes, by the way.

4. "Fund Category = All Domestic Stock"
For the purposes of narrowing down the results a bit, we'll examine only domestic-equity index funds in our example. In your own searches, though, feel free to look for international and fixed-income index funds.

5. "Closed to New Investment = No"
It might sound odd, but index funds have closed to new investors.

6. "Expense Ratio <= 0.36"
There are plenty of different cost cutoff points you could use for index funds, but we think they're important to consider. Several index funds have high expense ratios that we'd be wary of even for actively managed funds. We came up with 0.36% here on the rationale that it's tough to consider a fund that's more than double the industry standard--the Vanguard 500 Index.

Click here to run this screen for yourself. As of June 24, 2005, it yields 24 results. We'll describe three interesting options below.

 Fidelity Spartan Total Market Index 
Rob Arnott isn't the first to consider ways to upgrade the traditional S&P 500 index fund. While the S&P 500 Index does simulate the returns of the overall domestic stock market, it's certainly an imperfect bogy; it skews heavily toward larger stocks and its stocks are chosen by committee. Indexes that better reflect the full market include the Russell 3000 Index and the Wilshire 5000 Index, which is what this fund tracks. This fund isn't the first total market index fund, but in late 2004 Fidelity made it arguably the best when it slashed the expense ratio to a paper-thin 0.10%. We think it's a great way to get one-stop shopping to the whole domestic-equity market.

 Vanguard Balanced Index (VBINX)
Moving a bit further afield, this fund has two sleeves, one devoted to equities and one devoted to bonds. The basis of the stock segment is gradually changing from the Wilshire 5000 to the MSCI U.S. Broad Market Index--a change that will be transparent to most investors and still gives exposure to nearly the total U.S. equity market. The bond sleeve, meanwhile, mirrors the Lehman Aggregate Index, the key index for domestic investment-grade bonds. The fund maintains a constant 60% stock/40% fixed-income split. For investors with the right risk/reward profile, this fund could be a solid one-fund portfolio.

 Vanguard Tax-Managed Small Cap (VTMSX)
Some believe that indexing small caps doesn't hold the advantages that indexing large caps does; active managers, they argue, can "add value" in smaller stocks. Since its early 1999 inception this fund's returns have been just a touch above the average small-blend category member's, so although it hasn't made an overwhelming case for itself, it's hard to say that it's a lemon. Another knock on small-cap index funds is that they're tax inefficient because they must sell their winners as those stocks graduate to mid-cap territory. Manager Michael Buek uses sampling to track the relatively tax-efficient S&P 600 Index--and he also leans toward those stocks that don't have dividends to minimize taxes.