The case against index funds

Kenneth L. Fisher, Forbes Magazine, 02.22.99, 12:00 AM ET

SEVERAL READERS READ my Jan. 25 column "Report Card" and e-mailed asking, "Since this column's 1998 advice only matched the S&P 500's return, why not simply buy an index fund and tune out?"

It depends. An index fund is nothing more than a tool, and isn't inherently good or bad. Like a hammer, it depends on what you use it for and how good you are with it.

Note first, my advice is much more diversified than the S&P 500, which is valuable. Here you get global diversification to reduce risk.

Matching the S&P with globalness beats just owning the S&P. You get good U.S. and good foreign returns. If and when the U.S. market lags, S&P 500 index fund holders will be sorry. This column's 1998 advice beat the overall world stock market by more than 4%.

Similarly, the S&P 500 is more specialized and less diversified than you may think. It doesn't act like all stocks, but like a specific subset of U.S. stocks: huge growth stocks. It has an average dollar- weighted market capitalization of $90 billion. That is, it acts like a $90 billion U.S. stock. Huge. And like a growth stock, selling at 8 times book value, 30 times earnings and 3 times sales. The rub?

Sometimes huge stocks pay off. Sometimes they don't. Sometimes growth stocks pay off and sometimes they don't. Sometimes U.S. stocks pay off and sometimes they don't. It's not impossible to have a year in which all three factors reverse, and small beats big, value beats growth and overseas markets beat the U.S. market. The S&P 500 is unique enough to be potentially risky, part of why it has done so well.

Then, too, comes behavioral finance with powerful arguments against index funds. If you turn to me, or others, for advice, you must feel some need for advice. There is more than ample evidence that folks who are in need of advice will misuse index funds. They either try to time the market or they panic in a downturn. Index funds are easy to buy and too easy to sell.

If you're a great market timer, which few folks are, then you may well use index funds to buy low and sell high. But normal folks who discover index funds late in a bull market won't use those funds to be long-term investors, even if they think they will. Instead, most of them will sell out late in a bear market, hurting themselves.

People forget that late in a bear market a general consensus builds that stocks will never again be worthwhile. It gets very easy to sell out then, and there is nothing easier to sell than an index fund.

The normal investor's brain works with what behavioralists call "mental accounting." There is a decision "tree" or mental process associated with every single investment you have. If you have 50 stocks, it takes a lot more internal crunching and mental agony to sell out than if you have just one stock, an index fund.

I would hate to see you sell out at the bottom and take a real loss a few years from now. At the right time, I hope to advise you out of stocks. But for now, stick to my basic allocation, which is to be 100% invested in stocks, with 67% of that from among the 30 largest U.S. stocks. The other 33% should be in huge high-quality foreign stocks with a handful of global Japanese exporters. Ones like these: At 55% of sales and a cheap-by-Japanese-standards P/E of 18, Sony (73, SNE, www.sony.com) is a good way to pick up a great consumer products powerhouse. Global diversity, leading brand names, and positions in technologies like DVD, HDTV and MiniDisc, and a game division growing at 50% annually: These all position Sony to prosper in the next century.

Australia's News Corp. (30, NWS, www.newscorp.com) is another great global play. You may not appreciate Rupert Murdoch's influence, but if you enjoy Fox, the Los Angeles Dodgers, TV Guide, Harper-Collins publications, or virtually any news rag in the U.K., News Corp. grabs your attention. So should its value.

Oil prices will eventually rise, following the recent splurge of global money growth. France's Elf Aquitaine (55, ELF, www.elf.com) is the world's sixth-largest oil firm, plus, it has high-margin chemicals and specialty products. It also owns a 52% stake in health and beauty concern Sanofi -- worth fully one-third of Elf's market value. Sell if it gets to 95 by 2001.

Kenneth L. Fisher is a Woodside, Calif.-based money manager. His third book is 100 Minds that Made the Market. E-mail:kenfisher@fi.com