As readers know, I’m a longtime booster of index mutual funds. These funds follow the market as a whole. Tons of research has shown that most money managers don’t beat the markets they invest in, after costs. Maybe your own stocks or funds have excelled in the past couple of years, but the odds are against you in the long run. Indexing puts the odds on your side.
Today, however, there’s more than one way of indexing. You can buy classic index mutual funds, or you can buy index stocks that trade on a stock exchange.
Another look: In the past I’ve stuck with the no-load funds because they don’t cost you a brokerage commission. But with discount commissions so low, the question is worth another look.
Which brings me to SPDRs, a.k.a. Standard & Poor’s Depositary Receipts, a.k.a. Spiders, a.k.a. index stocks. Each one tracks the performance of a particular market index. The original daddy longlegs of Spiders follows the S&P index of 500 leading stocks. You’re buying them all in a single share.
You can also track the S&P by owning an index mutual fund. So what are the differences between the stock and the fund? Try these:
The S&P 500 Spider is only one of many new index stocks. There are nine sector Spiders that focus on portions of the S&P index, such as energy or technology; a Spider for midsize companies; Diamonds, which track the Dow Jones industrials; Qubes, for the Nasdaq index of 100 top stocks, and 17 Webs that track various foreign markets (Japan is the most popular now).
Barclays Global Investors, which manages the Webs, will soon launch as many as 47 new index stocks, mirroring various small-, midsize- and big-stock indexes, as well as sector stocks, in industries such as health care and the Internet. State Street Global Advisors, which manages Spiders, will launch an additional nine. Some of these stocks will catch on; others won’t.
Dizzy choice: What are indexers to do with this dizzying choice? Sit on their tuffets, I hope, and think things through.
Long-term investors could, in theory, build a permanent portfolio of well-diversified index stocks. “But then there’s a risk that you’ll give in to emotional trading, rather than staying put,” says planner Rich Rysiewski of Shelby Township, Mich.
A low-cost fund group like Vanguard is competitive with index stocks, and offers funds for big stocks, small stocks, internationals and emerging markets. You’ll definitely want a fund if you’re making regular monthly investments. Paying commission for index stocks would eat you up.
On the other hand, index stocks for foreign countries or industry sectors may be cheaper than the corresponding funds. Index stocks will also appeal to timers and traders trying to beat the pros, and to people who want to gamble on certain industry sectors.
There’s one potential difference between the funds and the stocks I haven’t mentioned. That’s the question of what might occur if share prices plunge.
Diversified index mutual funds contain huge, untaxed capital gains. The anti-fund claque loves to warn that if investors flee, the funds might have to liquidate some of their profitable stocks. That would leave the remaining shareholders with a tax bill for capital gains. Such a thing couldn’t happen with the new index stocks.
But Brian Mattes of Vanguard calls the tax fear an “urban myth,” like the crocodiles that are supposed to live in New York City’s sewers. If the market fell 20 percent, he says, nearly 40 percent of the shares in Vanguard’s $108 billion S&P 500 fund would have to be redeemed before the fund had to realize a dollar of capital gain.
That’s a pretty small chance. What is it about tax threats that scares smart people silly? Index stocks, by the way, have not yet endured a major bear market. No one knows how they’ll perform.
All that said, index stocks should greatly expand the market for indexing in general, especially among the brokers and planners who charge sales commissions, says Lee Kranefuss, CEO of Barclays’ individual-investor business. They can now introduce you to indexing and still earn money on the sale. And compared with actively managed mutual funds (the kind run by stock pickers), index stocks are more tax-efficient. They don’t pay out capital gains until you sell.
You and I are the winners in this ongoing indexing revolution. We’re getting more efficient products–one more step toward forcing down investment costs. Bring on the Spiders. I’m prepared.
