The recent decline of the Dow to early-1996 levels poses a number of potential problems for US investors.

The US equity market is probably the most heavily indexed in the world. Estimates put the level of index-tracking at around 10% of market capitalisation. Around $90bn-100bn of this is in mutual fund assets, the bulk of the remainder in institutional portfolios and the rest in foreign-based portfolios. Obviously, when a heavily indexed market undergoes a painful correction, investor capital is hit hard. Institutional investors are in a slightly better position than retail investors in that they have been looking further afield than US equities for some time, but retail investors were buying index funds with a passion during early 1997. This helped take the market ever upward. If this is now followed by a redemption frenzy, the market might be given that extra unwanted push downward.

This is, however, only the start of the problem. The 10% estimate really only accounts for officially” indexed assets. The truth of the matter is that in a bull market it becomes difficult for active managers to outdo the market benchmark consistently, and thus some managers often seek to replicate the benchmark to a high degree (without seeking perfect or near-perfect correlation). The problem for these managers is that, when the market goes down and investors redeem, assets have to be sold, and the downward pressure on the market is increased.

If the US market continues to slide it is more than likely that US investors (who have been relatively stoical thus far) will start to try to cut their losses and sell, and then the market may well enter a period of turmoil. The problem is to identify how much money is tracking the index without it being obvious and having to get hold of the detailed portfolio holdings of several thousand vehicles.

One method is style analysis. Although not an exact science, it can give a very good indication of how an individual fund is being managed. Style analysis of the generalist US equity fund sectors suggests that around a third of all US equity fund assets are “closet-indexed” in America. This represents around $500bn, a further 8% of the market. Although it has been losing favour with US retail investors in recent months (mainly to index-tracking funds) Fidelity Magellan Fund remains the largest US mutual fund and a firm favourite among institutional investors, plan sponsors and others.

The brown mass in the top right-hand corner of the top chart shows how quickly this fund appears to have adopted a portion of its portfolio to mirror the index, although the fund also appears to have been taking a position among medium-sized growth stocks. The sudden rise of the index portion adequately reflects the trend in the marketplace during this period. In fact, the 52-week correlation of Fidelity Magellan to the S&P500 Index in 1996 was 0.95 (R2).