Having established its credentials, indexing is set to expand in the US and elsewhere, says Frank Satterthwaite of Vanguard

Index investing - attempting to match the performance of a specific financial market benchmark - has truly come of age. During the past quarter-century, index investing has been transformed from a controversial and untested academic concept to a proven investment technique embraced by millions of investors.

US pension funds have the highest percentage of equity assets indexed (approximately 25%), followed by the UK (about 20%) and by Switzerland and the Netherlands (between 12% and 15%). The share of indexed assets is expected to rise both in the US and in Europe. In the US, for example, index mutual funds attracted net investments of more than $30bn, or 23% of the total cash flowing into US equity funds during the first nine months of 1998.

The Power of Low Cost: The movement toward matching the market return instead of trying to exceed it does not represent a lack of ambition on the part of pension funds. Instead, it represents a growing understanding that matching the market is a winner's game, and that active management of investment portfolios is - in the aggregate - a loser's game.

The theory behind indexing is simple: Lower costs translate into higher performance. In the aggregate, all investors in a given market, such as the US equities, must match the returns of the overall market, before subtracting the costs of investing. If you think of the market return as a pie to be divided among investors, you can see that for one investor to earn a larger slice of the returns, another investor must get a smaller slice. On average, half the investors will earn above-average returns and half will earn below-average returns. But all investors as a group must earn something less than the market return once expenses are taken into account.

All investors, pension funds and mutual funds included, have operating costs (advisory fees, salaries, office and equipment expenses, etc) and transaction costs (including brokerage commissions and spreads between bid and asked prices). For US mutual funds, these costs average about 2 percentage points per annum - which is approximately the gap between the long-term performance of the average mutual fund and that of the broad market indexes. Low-cost index funds can keep combined operating and transaction costs to perhaps 0.3% per annum, with approximately half of their cost advantage due to lower operating expenses, and half to reduced trading activity.

The 'secret' to index investing is that by minimizing both operating and transaction costs through a strategy of buying and holding all (or a representative sample) of the securities in a market index, the index investor earns something very close to the market return. Actively managed investment funds, meanwhile, are fated as a group to lag the market return because they incur higher operating costs (including salaries for securities analysts and portfolio managers) and transaction costs (because of more frequent trading). Index investing wins, in effect, by losing less of the return 'pie' to costs. Active portfolio management loses because - once costs are subtracted from gross market returns - the active managers are contesting a smaller pie. This basic arithmetic holds true in down markets as well as up markets.

It is true that a minority of active managers will beat the market averages during any given period, either by skill or luck (it's impossible to know whether skill or luck is the reason until a manager has a very long track record).

The trouble for a pension fund trustee is trying to identify in advance which managers will be able to outperform the market in the future, selecting winners in advance is devilishly difficult.

Indexing in Practice: The first indexed mutual fund in the US was introduced in 1976. That fund - Vanguard 500 Index Fund - seeks to match the performance of the Standard & Poor's 500 Composite Stock Price Index, an oft-used proxy for the US equity market.

As shown in Figure 1, indexing in practice has worked just as theory suggested it would. Over the past decade, the S&P 500 Index outperformed, on average, about two-thirds of US equity funds each year. The consistency of the index was notable. It only occasionally nudged into the top quartile of returns in a given year, but never fell into the bottom quartile. The longer-term result was superior. During the 10 years ended September 30, 1998, the S&P 500 Index outperformed 90% of all general equity funds in the US.

It must be conceded that the S&P 500 Index is not a perfect benchmark for US equities. The S&P 500 is dominated by large-capitalisation stocks (representing about 70% of the entire market's value), whose performance has been extraordinary in recent years. Actual pension or mutual funds, of course, can invest in small- and medium-cap stocks as well as large-cap stocks. Therefore, a more even-handed comparisonfor equity mutual funds is the total US equity market - as measured by the Wilsh ire 5000 Equity Index. This comparison reaffirms the power of indexing: The Wilshire 5000 Index outperformed the average equity fund in eight of 10 years from 1988 through 1997. During the 10-year period ended September 30, 1998, the Wilshire 5000 outperformed 80% of all equity funds.

Trends in Index Investing: Index investing is moving well beyond the S&P 500. It is being applied to other segments of the US equity market, to global stock markets, and to other asset classes, including bonds and shares of real estate investment trusts.

The inherent advantage of indexing - low cost - applies in all segments of the financial markets. Even in relatively inefficient markets - such as emerging stock markets - indexing has proven effective. In less-liquid and less-efficient markets, active portfolio managers have a greater chance to add value through their security selections. However, research and transaction costs tend to be significantly higher in such markets, which highlights the low-cost advantage of indexing.

Within the US markets, portfolios have been tied to indexes of mid- and small-capitalisation stocks, growth and value

stocks, fixed-income securities, and property trusts. Funds also have been created to track broad international equity indexes as well as indexes covering European, Asian, and emerging-market equities. Pension funds and individual investors alike have found indexed portfolios to be useful for gaining low-cost exposure to discrete market segments (intermediate-term bonds, or small-capitalisation growth stocks, for example) as well as to very broad asset classes (the total US equity market).

Figure 2 depicts the percentage of US fixed-income funds outperformed by the Lehman Aggregate Bond Index each year 1988 through 1997 and for the 10-year period ended September 30, 1998. As with equity indexing, consistent year-to-year performance has resulted in a superior long-term record for bond indexing.

The use of pooled investment vehicles, as opposed to segregated accounts, helps provide economies of scale and more effective investing techniques, thus making the most of index investing's secret - low operating and transaction costs.

Index Investing Caveats: Indexing is not magic. It works because costs, simply put, steal a portion of the market return from investors. By minimising the slice of the pie taken by operating and transaction costs, index investing leaves more for the investor.

Index investing can't protect investors from market risks. A well-run, low-cost index portfolio will closely track the market return, whether that is positive or negative. Also, some market segments may be too narrow or illiquid to allow for effective indexing.

Nevertheless, the continued growth of index investing seems assured because low costs, competitive long-term performance, and simplicity are advantages too compelling to ignore.

Frank Satterthwaite is managing director of Vanguard Marketing International in Brussels