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Even in Bearish World Index Funds Keep Going Strong

Danny Hakim.
Produced by
The New York Times

Market Place Autopilot is looking pretty good these days.

In the mutual fund industry, most money managers try to beat the market by picking the right securities. But in these bearish times, index funds that simply mimic the performance of popular stock and bond indexes are taking the lead.

Not only are index funds outperforming actively managed funds, but the Vanguard Group, which invented the index mutual fund in the 1970's, has reclaimed its title as the most popular, in terms of combined sales of stock and bond funds. Four of the nation's 12 best-selling funds are Vanguard index funds, according to the Financial Research Corporation, which tracks money flows into mutual funds.

People once obsessed with finding the next Yahoo (news/quote) or sure-fire Internet mutual fund have tamed their inner investor. They are looking to less turbocharged index funds, and increasingly to the relative safety of bonds. In July, stock funds had their first month of net withdrawals since March, according to a new projection from Lipper Inc., a fund tracking firm.

Investors flocked to index funds in the middle and late 1990's as stock indexes soared and index funds tended to beat actively managed funds, after trailing in the early 90's. Vanguard, the nation's second-largest fund management firm behind Fidelity Investments, became the leader in new fund sales in the late 1990's. But last year, it relinquished its sales title to Janus Capital of Denver. Janus's managers tried aggressively to beat the market by making bets on stocks like Nokia (news/quote).

But over the last year, investors have been fleeing Janus as its funds have plummeted, and the assets of the company have plunged from $330 billion in March 2000 to $200 billion at the end of July — a staggering decline of almost 40 percent that has sliced away at the profits of its parent company, Stilwell Financial (news/quote), a Kansas financial holding company.

The relative merits of the index fund versus the actively managed fund are a matter of continuing debate in the mutual fund industry, a man versus computer struggle. For some investors, the idea of buying an index fund seems like giving up. And, in a swooning market, index funds might not have obvious appeal. Why would anyone want to be invested in a fund that is programmed to follow the Standard & Poor's 500 off a cliff?

One reason is that many of the fund managers who are paid to beat the market are doing even worse than the S.& P. 500. For the first seven months of the year, the average diversified domestic stock index fund was down 8.4 percent. Not so great. But the average diversified fund that was actively managed lost 10.3 percent, according to Morningstar Inc., a Chicago fund-tracking firm.

Such a comparison lumps together many types and styles of funds. To be more precise, the $90.6 billion Vanguard 500 Index Trust, the nation's largest mutual fund and the first to mimic the S.& P. 500, was down 7.7 percent this year through the end of July, but 2 percentage points ahead of the average actively managed fund in the same Morningstar category. Last year, the Vanguard 500 trailed the comparable actively managed fund by more than 3.5 percentage points, trailing for the first time since 1993. Over 10 and 15 years, the Vanguard 500 has beaten the average actively managed fund by more than 2 percentage points a year.

"People make two wild assumptions," said George U. Sauter, who runs Vanguard's indexing operations. "They think active managers will know when to time the market and when to get out. I'm not sure why people think they have such great analytical abilities in a bear market when they don't distinguish themselves in a bull market."

Actively managed funds charge more, because it is more labor intensive to hire managers and analysts to devise strategies to beat the market, and they usually have greater trading costs. And they tend to offer only limited protection, since they usually cannot move too heavily into cash or bet against the market.

But it would be foolish to discount the entire category. Most financial planners emphasize diversification and a role for both kinds of funds. And even Mr. Sauter runs — and invests his own money — in an actively managed fund for Vanguard. Fidelity Investments, the nation's largest manager of mutual funds, defends the active fund by pointing to those that do beat the market. Five of its largest funds have beaten the S.& P. 500 over the last decade. They include Fidelity Magellan, the nation's second-largest fund, as well as Contrafund and the Fidelity Growth Company fund.

"We strongly believe in actively managed funds and believe they can do well versus the index over time," said Rick Spillane, a Fidelity senior vice president who oversees the company's United States stock funds.

"Beating the market is not easy. It's cyclical, like a roller coaster," he added. "Stocks that have done well this year are autos, paper and forest, gold. Most funds aren't heavily invested in those areas."

Roy Diliberto, a Philadelphia financial planner, suggested something like a 50-50 mix of indexing and active management for his clients.

"Some years, indexing works better and sometimes actively managed funds work better," he said.

Harold Evensky, a financial planner in Coral Gables, Fla., said that index funds "always do better" but that actively managed funds were advisable in certain areas, including international investing, particularly emerging markets, and can be better for investing in small companies — areas where there are more inefficiencies to exploit. But he recommended index funds for all large- company investing.

"An index fund, at a minimum, is going to be average," he said. "And because active managers have both management fees and transaction costs, they have to be better than average. And, the catch is, they have to be better than average consistently."

(c) Copyright: The New York Times

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