Index Funds

Investment Manager's Letter February 2000

Tom Gardner made the following quote last year. He is one of the bothers that founded "The Motley Fool" a popular investment Web site.

"The Efficient Markets Theory was under thoughtful and overloved. But it did bring us a wonderful new vehicle - the index fund. The market-index fund is going to wreak havoc on the mutual fund industry over the next five years. I've secured my box seat. Can't wait to spectate."

Are Index Funds really a wonderful New Vehicle? Yes, it is true that Index Funds have outperformed most managed stock funds, and I, as investment manager, agree with his contention that the mutual fund industry is in for a very traumatic future. But, I, as investment manager, am not at all sure that index funds are going to be a positive alternative. In capital markets the past is the past, and the only constant is change. Just because Index funds have out performed managed funds for the last 15 years does not mean they will for the next 15.

Because of their record, Index funds have collected huge amounts of money. There are hundreds of index funds now available, and to make things worse, many large "managed" funds have become closet indexers. The result has been a huge flow of funds into a small number of stocks of companies that dominate the S&P Index. The S&P 500 is a weighted index that means that a large percentage of the money that flows into index funds ends up invested in the stocks of the 50 companies in the index with the largest Market capitalization. The result is that they have become overvalued relative to the rest of the market.

In the market today, there are large areas of over valuations (Tech stocks and large caps) but there are also pockets of under valuation. In the small cap sector (non-tech) equity values are very depressed. Many PE's are at levels not seen since the 1970's. Indexing is partially responsible for this. Small companies receive little if any of the money that flows into index funds. In addition the rest of the Mutual funds have grown so big that they can not invest in small companies. Their capital base is so big and the frictional costs of getting into and out of a position in a small company has become really scary.

We have a Market were most big companies (particularly the top 50 or so) are over valued and most small companies are undervalued. This is a condition that has gone on for so long now that no one notices it anymore. Markets are not completely efficient, but there are mostly efficient. This means that inefficiencies in the market can go on for a while (sometimes quite a while), but sooner or later they will be corrected.

When this correction comes small stocks will increase in value relative to big stocks. This is not the type market that will make it easy for index funds to out perform the rest of the market. It is likely; that this will not be a pleasant time for large managed mutual funds. But it may also mean that index funds will offer a very mediocre alternative.

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