Critics of Indexing Aren't Making Sense
Jonathan Clements The Wall Street Journal Tuesday, April 25, 2000

Amid the stock market's recent travails, critics are once again taking aim at index funds. But like the firing squad that stands in a circle, they aren't making a whole lot of sense.

Indexing, of course, has never been popular in some quarters. Performance-hungry investors loathe the idea of buying index funds and abandoning all chance of beating the market averages. Meanwhile, most Wall Street firms would love indexing to fall from favor because there isn't much money to be made running index funds.

But the latest barrage of nonsense also reflects today's peculiar stock market. Here is a look at four recent complaints about index funds:

They're undiversified: Critics charge that the most popular index funds, those that track the Standard & Poor's 500-stock index, are too focused on a small number of stocks and a single sector, technology.

S&P 500 funds currently have 25.3% of their money in their 10-largest stockholdings and 31.1% of assets in technology companies. This narrow focus made S&P 500 funds especially vulnerable during this year's market swoon.

But the same complaint could be leveled at actively managed funds. According to Chicago researchers Morningstar Inc., diversified U.S. stock funds have an average 36.2% invested in their 10-largest stocks, with 29.1% in technology.

Moreover, today's S&P 500 is about as diversified as it was two decades ago. At year-end 1980, the 10-largest holdings accounted for 25.6% of the S&P 500, with energy stocks taking up 29.7% of the index, according to Vanguard Group, the Malvern, Pa., fund company.

They're top-heavy: Critics also charge that S&P 500 funds represent a big bet on big-company stocks. True enough. I have often argued that most folks would be better off indexing the Wilshire 5000, which includes most regularly traded U.S. stocks, including both large and small companies.

But let's not get carried away. The S&P 500 isn't that narrowly focused. After all, it represents 77.2% of U.S. stock-market value.

Whether you index the S&P 500 or the Wilshire 5000, what you are getting is a fund that pretty much mirrors the U.S. market. If you think index funds are undiversified and top-heavy, there can only be one reason: The market is undiversified and top-heavy.

"It's not that index funds are getting riskier and riskier in a vacuum," says Gus Sauter, Vanguard's managing director in charge of index funds. "The market is getting riskier, and index funds merely reflect that."

If that risk makes you uncomfortable, you could take a pass on Wilshire 5000-index funds and instead overweight smaller companies or overweight value stocks. But in doing so, you are deviating from the market's weighting -- and that, too, is risky.

"The risk is that you avoid a certain portion of the market that will continue to rise," Mr. Sauter says. "If you decided two years ago that large stocks were too expensive and you moved into the small part of the market, you cost yourself a great opportunity."

They're chasing performance: In recent years, the stock market's return has been driven by a relatively small number of sizzling performers. As these hot stocks climbed in value, index funds became more heavily invested in these companies, while lightening up on lackluster performers.

That, complain critics, is the equivalent of buying high and selling low. A devastating criticism? Hardly. This is what all investors do. When Home Depot's stock climbs 5%, investors collectively end up with 5% more money riding on Home Depot's shares.

"These biggest positions grew into their outsized positions," says Jerry Tweddell, an investment adviser in Sonora, Calif. "You're letting the flowers grow, and you're letting the weeds wither. Isn't that what you want?"

You can do better: Sure, there is always a chance you will get lucky and beat the market. But don't count on it.

As a group, investors in U.S. stocks can't outperform the market because, collectively, they are the market. In fact, once you figure in investment costs, active investors are destined to lag behind Wilshire 5000-index funds, because these active investors incur far higher investment costs.

But this isn't just a matter of logic. The proof is also in the numbers. Over the past decade, only 28% of U.S. stock funds managed to beat the Wilshire 5000, according to Vanguard.

The problem is, the long-term argument for indexing gets forgotten in the rush to embrace the latest, hottest funds. An indexing strategy will beat most funds in most years. But in any given year, there will always be some funds that do better than the index. These winners garner heaps of publicity, which whets investors' appetites and encourages them to try their luck at beating the market.

It is akin to the lottery. We only ever hear about the winners. Their tales of gaudy riches spur others to buy lottery tickets. But the grim reality is, most lottery-ticket buyers never win anything more than the sympathy of the convenience-store clerk.

Write to Jonathan Clements at

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