A discussion yesterday on "indexing" a way of investing meant to minimze fees and give an investor the return of a given index deserves a discussion.

Issue 1, investing is NOT a religion... yet some people swear by indexing more than they go to church.

Issue 2, make sure you understand the index (NEVER invest in something you don't understand). The popular indexes used are S&P 500 (large cap stocks), Wilshire 5000 (the top "5000" companies in the country), the Wilshire 4500 (the top "4500" companies with EXCEPTION of the top 500-S&P 500), and the Russell 2000 ("2000" small companies).

Issue 3 managed funds will compare themselves to an appropriate index. Fees matter. Some managed funds charge .69% (T Rowe Equity Income) and .73% (T Rowe Captial Appreciation)expense ratios. Index funds charge ~.35% (TRP equity index) to .18% (Vanguard Index 500) to .07% (Fidelity Spartan 500).

Issue 4. RISK. Risk can be defined as volatility- the liklhood returns will vary significantly. If a person accepts risk, they are accepting variance of returns. If a person wants less risk, they are usually willing to sacrafice the high end to avoid the low end.
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I want to combine these issues, concetrating on S&P 500, the most popular index.

Do you know why a company is in the S&P 500? If you believe investing in only things you understand, but cannot answer this question, it appears you do not practice what you preach.

My understanding is a group of people which work for "standard and poors" (S&P) decide the 500 companies which are proxies for the whole market. Not the 500 largest, not the 500 fastest growing, not the 500 best values, but some random group of 500 stocks.

The index does change year over year. Companies get dropped and added as S&P people see fit. These people at S&P have no vested interest in anyone in an index fund making money.

Most S&P 500 index funds own all 500 stocks in the index. The mutual fund is broadly diversified (owns 500 stocks, most managed funds own 100-200 stocks). They own the bad ones (like Enron), they own companies in bankruptcy (like Dana, Xerox, Ford, GM) until the companies are removed from the index.

This is "downside" risk. If a person owns an index fund, they own these companies "on their way down", with no mechanism to dump the losers.


It gets much more cloudy with Wilshire 5000. For one thing, the Wilshire 5000 index has more than 5000 stocks in it. WHAT? Yes, it has ~5700 stocks in it last I looked. Second is a Wilshire 5000 index fund will NOT own all "5000" stocks. It will own a SAMPLE of the 5000 stocks. Index has 5700 and fund owns less than 5000. WHAT GIVES?

Two problems with this. First is if index has more the 5700 companies, couldn't the people creating the index make a decision as to what to remove? Second if the fund manager now has to make a decision as to what he does or does not buy (he cannot buy 5700 stocks, it would be WAY too costly), what does he decide to buy and WHY. Why is not listed in fund prospectus. Invest in what you understand.

So in reality a wilshire 5000, wilshire 4500 or russel 2000 index fund is being "managed", a person is choosing what stocks in the index to put into the fund which is owned by a customer.

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Control and Accountability. Those are probably two words most people want in most things in life.

This is why I choose managed funds. My fund manager is accountable to me. I have control over the types of companies I invest in based on the fund manager I choose.

The risk of a managed fund is if the manager misses a "good stock" on it's way up. The advantage of a managed fund is the fund manager does not have to ride a stock on it's way down.

Xerox is a good example. it was a high flying stock in the 90's. High dividend, high yield. excellent performance. I used to work for Xerox, and also owned the stock (XRX). My father even retired from Xerox. Then speculation started about bankruptcy. Any managed fund in their right mind dropped the stock like a bad habit. price dropped. Then Xerox filed for bankruptcy. Stock dropped again and removed it's dividend (Xerox had previously reduced it's dividend prior to this when bankruptcy speculation started). An index owned the stock all the way down. Xerox is still part of S&P 500... so it brought the return down... where as most managed funds probably sold it.

The goal of managed funds is to reduce risk by not taking the ride down.

The examples I like to use are PRFDX and PRWCX. I will compare to VFINX (Vanguard 500 index, largest mutual fund in the world, I think).

PRFDX is T Rowe Price Equity Income
PRWCX is T Rowe Price Capital Appreciation


PRFDX expense ratio is .69%
PRWCX expense ratio is .73%
VFINX expense ratio is .18%

The question is, does .5% expenses get an investor out of the down cycle?

PRFDX returns

1997 28.82%
1998 9.23%
1999 3.82%
2000 13.12%
2001 1.64%
2002 -13.04%
2003 25.78%
2004 15.05%
2005 4.26%
2006 19.14%

PRWCX returns
1997 16.20%
1998 5.77%
1999 7.07%
2000 22.17%
2001 10.26%
2002 0.54%
2003 25.47%
2004 15.29%
2005 6.85%
2006 14.54%

VFINX returns
Year VFINX Category Diff
1997 33.19
1998 28.62
1999 21.07
2000 -9.06
2001 -12.02
2002 -22.15
2003 28.50
2004 10.74
2005 4.77
2006 15.64

note that 10 yr returns for each fund are
PRFDX 9.99%
PRWCX 12.26%
VFINX 7.55%

It's cool the two funds I mentioned beat the index, that was NOT the goal. The goal was an 8% return (which both exceeded) WITHOUT THE RISK. Look at the lows.

2001 and 2002 in particular. 2005 as well. The goal is to reduce risk, not beat the index. Beating the index is a measurement (if returns were significantly lower than the index, one could argue that less risk yielded a much lower return).

I will post a blog on risk tommorrow.