Venturing into the stock market with no intention of seeking out the stocks of individual firms with a seemingly bright future might appear to be a strange approach to equity investing. But the growing popularity of index funds across Europe suggests that more and more investors are doing exactly that.
Index tracker funds essentially buy the stocks that are part of an index--like the 30 firms that make up New York's Dow Jones Industrial Average--in an effort to mirror its performance. Thus when you hear that the FTSE 100 rose 1% in that day's trading, you would know that the portfolio in the tracker fund for that index should have made the same gain. Interest in these vehicles, which are also known as passively managed funds, has boomed recently. Within the past four years in Britain and on the Continent, the capital in index tracker funds monitored by Standard & Poor's Micropal, a fund research agency, has increased from $4.7 billion at the start of 1996 to about $24.4 billion in August last year.
Tracker funds certainly have their advantages. Because investment decisions are automatic and require smaller staff and less research, they can charge lower fees than actively managed funds. Then there's the issue of performance. According to Standard & Poor's Micropal, benchmarks like the MSCI Europe and the Dow Jones Euro Stoxx 50 rose about 27% and 29% respectively over the 12 months to mid-December, 1999. That compares to an average rise of 23% for pan-European active funds--those that invest in individual stocks based on the fundamentals of the companies behind the shares. Some of these actively managed funds recorded increases as high as 139%, while others tanked completely, losing as much as 20% of their value. But it's not just a few disasters that drag down the average--of the 485 active funds examined, only 105 outperformed the MSCI Europe and just 80 outperformed the Dow Jones Euro Stoxx 50.
An index-tracking investment strategy "is primarily about having control," says Chris Sutton, head of passive management strategy at Barclays Global Investors, who notes that in the past, "active management has delivered a number of unpleasant surprises." Investors like index-tracking funds, says Sutton, because the returns they deliver are in line with the benchmarks.
Not all advisers, however, think index trackers have the upper hand. Some experts criticize tracker funds precisely because of their link to market movements. "Investors' interest in passive funds is a byproduct of long-term great markets," says Allen Anderson, principal of the U.K. arm of retail stockbroker Edward Jones, adding that index funds have recently been carried along by strong European market performance. "A rising tide raises all boats," says Anderson. "When the market turns, these funds won't look nearly as attractive." In their attempt to replicate indexes, passive managers often buy stocks without regard for the fundamentals of the companies concerned, an approach which is anathema to active managers. "It's the whole rationale of active fund management," says Paul Moulton, chief executive of the investment consulting firm Fitzrovia International. "If you have a company when everyone can see it's doing badly, why should you hold it?"
Indeed, critics of passive funds caution that when the market heads downward, no fund manager will be around to bail investors out. Passive managers counter that active managers may also underperform in a falling market, and they add that in good times active managers may incorrectly anticipate a crisis and sell stocks prematurely, depriving investors of returns.
Differences aside, the one place where both types of funds can comfortably coexist is in a diversified retail portfolio. "Because of the low charges, it makes sense for retail investors to have a small holding in passive funds, but not everything," says Roger Guy, an active fund manager at Gartmore. "I would recommend about 20%." But investors should look carefully at what kind of index the fund they buy into is tracking. "I don't have that much of a problem with indexes, as long as they're broadly based," says Peter Sullivan, European equity strategist at Goldman Sachs. Financial advisers say tracker funds work best in developed markets, which have adequate liquidity. They can act as the core component of a retail investor's diversified share portfolio, which could expand to include actively managed funds (or even individually held shares) in specialist sectors like technology or specific regions like the Far East. But investors should be more cautious when buying specialist indexes because their performance tends to be more volatile than broadly based ones.
Retail investors should remember, however, that while index funds are designed to mirror benchmark performance, they are by nature subject to the vagaries of the broader market. They require an investment time horizon as long as for any active fund. Private investors entering the stock markets should be prepared to sit tight for at least five years. And it will help to have a strong stomach to ride out the inevitable ups and downs that will always be part of equity investing.