The Hidden Drawback of Indexing

Whether you're a sophisticated investor or a newbie, odds are you know the advantages of index funds. Index-fund 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 receive far less notice.

But 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--a topic we explored in October--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%.

Fast-forward to 2005. With Japan's economy having shown signs of recovery, and encouraging signs of reform having emerged in the corporate and political arenas, the market rose in 2003 and 2004. Then, after a brief lull, the Japanese market took off again in the second half of 2005. Because its gains were much higher than those posted by most other developed markets, Japan's share of EAFE soared. By the end of 2005, its weighting in EAFE-trackers such as  Vanguard Tax-Managed International (VTMGX) and  Fidelity Spartan International Index  had grown to about 25.7% of assets. In other words, shareholders in those funds are seeing more and more of their assets shifted into the very market that's been the hottest.

It's important to make clear that I'm not predicting an immediate downturn in Japan's market or saying that a 26% weighting there is too much. Who knows? Rather, the point is simply that EAFE-fund shareholders--and just as important, prospective shareholders--must be aware of this situation and be alert that if the trend continues, Japan's EAFE weighting could spike to 30% or higher, deepening the severity of the impact on index funds if that market does stumble.

Of course, astute readers will point out that index funds aren't the only ones that tend to boost their stakes in individual sectors or markets when they catch fire. Indeed, active managers commonly do the same thing. In fact, that's one reason many index funds have managed to rack up sound relative rankings in their categories despite the disadvantage described above. But there are plenty of topnotch managers that don't follow the crowd. Right now, for example,  Julius Baer International Equity (BJBIX) has just 15% of assets in Japan, and manager Rudolph-Riad Younes told Morningstar last week that figure is much more likely to fall than to rise. Similarly, Rob Lyon of  ICAP International (ICEUX) says he and his comanagers have cut their fund's Japan stake sharply in recent months; at roughly 17%, that position now stands well below the EAFE weighting.

Emerging Markets, Too
It's worth noting that EAFE-trackers aren't the only international funds susceptible to weighting creep. A similar process is going on at  Vanguard Total International Stock Index (VGTSX). That fund rests on an EAFE base (which consists of two other Vanguard funds that track the developed European and Pacific markets), but it also adds an emerging-markets stake in the form of  Vanguard Emerging Markets Stock Index (VEIEX). With emerging markets on an extended rally that's now several years old, Vanguard Total International's emerging-markets weighting has risen even more sharply than Japan's weighting in EAFE has.

The result: While Vanguard Emerging Markets had made up just 8% of Vanguard Total International at the end of 2001, that figure had climbed all the way to 13.8% by the close of 2005.

Again, I'm not calling that weighting dangerous in itself. Nor am I predicting an emerging-markets crash. And I'm not trying to diminish the value of Vanguard Total International. Rather, the point is this: As with Japan's growing weighting in the EAFE-trackers, the Vanguard Total International case shows that for all their admirable qualities, index funds are in effect momentum players. (Which, incidentally, is why some in the financial field now argue that index funds should be constructed on a different basis.) That doesn't make them unworthy holdings--far from it. But it's a trait investors would be unwise to ignore.