Buyer Beware

Bursting the Indexing Bubble

By Doug Fabian

At first glance the evidence for S&P 500 index funds seems overwhelming: the S&P is up 32% so far this year; the index beat 75% of all stocks funds last year; plus investment fees and tax liability are minimal given the low portfolio turnover.

It's no wonder then that the Vanguard Index 500 fund was the top-selling fund in 1996, pulling in more than $8 billion for a total asset base of $33 billion today. But don't be fooled: behind the S&P's recent strength lies a shady past.

Buying the Market?

Most investors mistakenly believe that when they purchase an S&P index fund they're "buying the market." However, what they're really getting is a piece of the market, and disproportionate one at that.

That's because the S&P is comprised of large-cap growth issues, which represent just a part of the U.S. economy. Sure these stocks do well during cycles of blue-chip growth, but they fail in small-cap moves. Case in point: the recent small-cap boom.

Since June of this year, small-cap stocks have been surging with close to 80% of all U.S. equity funds beating the S&P index since that time.

To understand these dynamics, it's important to realize that the S&P index is weighted by market capitalization, instead of equal weightings. This means larger-cap multinational stocks such as Coca-Cola, Gillette and Procter & Gamble have a bigger influence on the indice's moves. Thus their recent pullback has hindered the S&P. Couple this with the indice's large-cap composition, and it becomes clear that it can not take advantage of the market's renewed small-cap preference.

Indexing vs. Active Management

While the S&P has outperformed the majority of actively managed funds during certain periods, it's a mistake to think that is does so on a consistent basis.

Why? Because in addition to capturing small-cap moves, actively managed funds are able to position themselves in those stocks leading the market. As we've seen, bull markets are historically driven by specific sectors (energy stocks in the 70's, health care in the 80's and technology in the 90's). While an equity fund manger is able to take advantage of these changes in leadership, the S&P fund is limited to its 500 core holdings which restricts performance.

As the table shows below, the index beat just 15% of active managers in 1977. Likewise, in 1979 that figure was 20%. And more recently, in 1993 the index beat just 40% of active managers. Based on this evidence, it's clear that the index's recent strength is not part of a long-term trend. In fact, Vanguard itself acknowledges this in the Winter 1997 shareholder newsletter, stating that the market's 69% return over the past two years is "abnormal."

Percentage of Funds Outperforming the S&P


1977      85%

1978     69%

1979     80%

1980     47%

1981     63%



1982      62%

1983     40%

1984     22%

1985     26%

1986     24%



1988      41%

1989     18%

1990     36%

1991     55%

1992     54%



1993      60%

1994     22%

1995     15%

1996     25%

1997     5% (1/1 - 6/30)

            79% (6/30 - present)

What about Fees?

It's true that index funds in general have lower fees than those of their actively-managed counterparts. However, as mentioned above, they are unable to always lock into those sectors outper-forming the market, which hurts performance over the long-term. Actively-traded funds, on the other hand, are able to take advantage of small-cap and sector moves for above-average profits that more than offset expenses and taxes.

Your Best Bet

Forget indexing if your long-term goal is building wealth. Know the market. Be aware of current forces driving prices and take advantage of them using today's best actively-managed funds.


  1. What are the arguments made by the author against indexing?
  2. One of the arguments made against indexing is that index funds are unable to lock into those sectors that will outperform the market, and thus hurt performance in the long term. How would you respond?
  3. Looking at the table, it seems like the index underperforms active money managers in years in which the market does badly and outperforms in years in which the market does well. Why might this be so?