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With the Standard & Poor's 500-stock index down to 1997-98 levels, many of the millions of folks who automatically plunked money into funds based on that stock index may be wondering if index investing is a bust. "Most people, when they think of indexing, think of the S&P 500," says Gus Sauter, who heads Vanguard Group's index funds. "But there are many other indexes."
Indeed, if you had invested in Vanguard Mid Capitalization Index Fund, which tracks the S&P MidCap 400 index, you would've eked out a 3.9% three-year annualized return as of July 29, trouncing the S&P 500's 11.4% annualized loss and beating over 80% of other mid-cap funds. If you had bought a real estate stock index fund, you would've earned around 12% per year. Plus, index funds' low management fees and trading costs give them an edge of more than 1% a year over actively managed funds.
Keep in mind that by betting on a narrow market sector such as real estate, you're obeying the letter, but not the spirit, of indexing. Devotees of indexing, such as Vanguard founder John Bogle, argue that since few people can predict which sector or stocks will lead the market upward, investors are best off with the broadest possible market index so they can get at least a market rate of return. In U.S. stocks, the Wilshire 5000 index, which tracks more than 6,500 stocks, is the broadest.
But no matter what Bogle says, many investors prefer more narrowly based indexes. That's usually because they're uncomfortable with the companies that account for a big share of the broad indexes' value. Index funds hold stocks in the same proportion to share of total market capitalization. In the Wilshire 5000, for instance, the 100 largest stocks currently account for 56% of capitalization. At the Wilshire's peak in March, 2000, 44% of its value was in technology and telecommunications stocks. So when those sectors tanked, the Wilshire went down with them, falling at a 10.2% annualized rate over the past three years.
As their market capitalizations fell, tech and telecom shrank to 17% of the Wilshire 5000 and just under 20% of the S&P 500. But even so, they could remain a drag on returns if they continue to underperform. If you worry that telecommunications, technology, or others will remain dogs, consider choosing indexes that shun those sectors. By Lewis Braham