Don Phillips, managing director at Morningstar, offers his insight on whether market-cap weighted indexes serve investors’ best interests. He also discusses the risks associated with today’s specialized indexes and what steps providers can take to moderate those risks:
The bottom line is this; the index community is at a crossroads. It’s wandered so far from its roots of offering one-stop, broad-based exposure to the market that a return to that simpler approach may not be possible. In creating more complex offerings, the index community has found new revenue sources from hedge funds and other parties seeking very specialized tools, but it has done so at the risk of doing considerable harm to less sophisticated investors. The test of character facing the index community is whether it ignores that risk or steps up and tries to mitigate it.
Morningstar director of mutual fund research, Russel Kinnel, examines the role indexing plays in active and passive investing strategies. All too often, he says, the industry uses an incorrect proxy for indexing that can lead to the wrong conclusions:
For the trailing three years ending 2005, fewer than one-third of small-cap U.S. stock funds beat their respective Morningstar Index. Meanwhile, more than half of large-cap U.S. stock funds beat their respective index.
Index returns from July 1997 through January 2006 are shown below:
I particularly think that the following statements make a lot of sense for investors when selecting mutual funds:
Our studies have shown that lower-cost funds—regardless of whether they are active or passive—are a good bet. Maybe small caps really are less efficient than large caps despite what these figures show, but on another level, it doesn’t really matter. Either way, lower-cost funds are the way to go, and investors ought to do well whether they choose active or passive funds. And of course, investors can do better by focusing on other fundamentals, too, such as management, strategy, and asset size. When choosing an index fund, investors should look for one with low turnover, low costs, and a diversified portfolio.