When Index Funds Go Bad

Index funds have many attractive features: They're cheap, broadly diversified, and tax efficient. And active managers have had a hard time outmaneuvering them, particularly in the large-cap arena.  Vanguard 500 (VFINX), the most popular index fund by far, has generated total returns over the past decade that trump more than two thirds of actively managed large-cap funds.

But that's not the whole story. Although total return figures show how a fund has performed over a specified time frame, they don't accurately reflect shareholders' experience because they don't consider the timing of purchases and sales. Indeed, investors of all stripes are notorious for their poor timing: They often purchase investments after periods of strong performance and sell them belatedly after periods of weak performance. Those timing decisions thus have a major--and negative--impact on the returns shareholders actually pocket. As such, it's instructive to examine asset-weighted returns to gain a better understanding of how investors have really fared, because asset-weighted returns account for cash flows in and out of a fund.

And to get a better idea of how the average index investor fared, I examined asset-weighted returns on index funds that have been around at least 10 years. As most investors are painfully aware, the past decade included dramatic upswings and downswings that tested investors' discipline.

The results indicated that, as with most active funds, investors' timing decisions were costly when it came to index funds. The asset-weighted returns for virtually all large-cap index funds were worse than their official returns for the trailing 10-year period through the end of the third quarter 2005. As the table below shows, poor timing cost Vanguard 500 shareholders 2.7 percentage points of returns per year over the past decade. That's not chump change. Over a 10-year period, that amounts to more than $5,400. Similarly,  Fidelity Spartan 500 Index Investor shareholders sacrificed 4 percentage points per year over the past 10 years, or a cumulative total of almost $7,600. If that weren't bad enough, almost all large-blend index funds fell short of the category average on an asset-weighted basis, suggesting that index investors earned lower returns than the typical large-blend investor.

10-Year Asset-Weighted Returns vs. Official Returns
Mutual Fund	Asset-Weighted Returns	Official Returns	Gap
DFA U.S. Large Company	5.53	9.31	-3.78
Dreyfus Basic S&P 500 Stock (DSPIX)	6.10	9.24	-3.14
Dreyfus S&P 500 Index (PEOPX)	6.24	8.92	-2.68
Dryden Stock Index Z (PSIFX)	2.92	9.10	-6.18
Fidelity Spartan 500 Index	5.29	9.30	-4.01
Fidelity Spartan U.S. Eq. Index	6.95	9.31	-2.36
First American Equity Index	6.06	8.86	-2.80
JPMorgan Equity Index (HLEIX)	3.46	9.16	-5.70
SEI Index S&P 500	6.33	9.22	-2.89
SSgA S&P 500 Index (SVSPX)	7.38	9.29	-1.91
T. Rowe Price Equity Index 500 (PREIX)	6.03	9.18	-3.15
Vanguard 500 (VFINX)	6.72	9.42	-2.70
Vanguard Institutional Index (VINIX)	6.68	9.55	-2.87
Vanguard Tax-Mngd Gr. and Inc.	4.13	9.51	-5.38
Vanguard Total Stock Market (VTSMX)	6.05	9.32	-3.27
Wells Fargo Advantage Eq. Index	10.49	8.66	1.83
Wells Fargo Advantage	8.43	9.23	-0.80
Morningstar Data as of 9/30/05

It's telling that many institutional index funds, which tend to have more stable asset flows, fared better than retail offerings. For example, Wells Fargo Advantage Index , which has the vast majority of assets in its institutional shares, had asset-weighted and official returns that varied by only 0.8 percentage points. It helped that in 1999, when the S&P 500 was reaching its zenith, this fund's assets held steady, while most index funds experienced large inflows. For instance, Fidelity Spartan S&P 500 Index's total assets increased by almost 50% that year.

So is performance chasing to blame for these poor results? I certainly think that had a lot to do with it. Index funds offered an easy way to gain exposure to a hot stock market in the late 1990s. Large-cap stocks in particular were on fire during that time, luring many investors to large-cap heavy S&P 500 Index funds. Granted, indexing as an investment strategy was catching on with investors at about the same time, but I suspect that their popularity had more to do with the S&P's scorching bull-market campaign.

As indexing became more popular, fund companies rushed to meet the demand by introducing index funds that bore their brand names. More than a third of large-blend index funds opened their doors between 1997 and 1999, and more large-cap index funds were rolled out in 1999 than in any other year. Although fund companies can't control investor behavior, marketing moves frequently encourage investors' worst tendencies.

Clearly, index investors aren't immune from the behavioral biases that can produce bad results from good funds. Although many of indexing's most vocal proponents (Burton Malkiel and Jack Bogle, for example) also preach the importance of disciplined, long-term investing, it appears that many investors didn't heed that advice. True, investors were challenged by one of the most precipitous bubbles in stock market history, and I take some comfort from the fact that asset flows into index funds have smoothed out over the past few years. But many still have a propensity to pile into the hottest funds at just the wrong time. Witness the recent strong inflows many energy funds have experienced this year. I mistakenly assumed that index funds were less likely to invite such behavior, but this study proved me wrong. I still think index funds provide investors a great way to get low-cost, no-fuss exposure to the stock market, but they are good investments only if shareholders use them wisely and maintain the long-term orientation that's necessary to benefit from all they have to offer.