Investors dazzled by ... indexes?

Index funds remain at the core of millions of investment portfolios.

And for good reason: These funds, which seek to match the performance of market indexes such as the Standard & Poor's 500 Index, appeal to investors hoping to escape the volatility of the stock and bond markets in the late 1990s.

Once mocked for their plain vanilla approach, index funds are moving to the top of the investment class, measured by dollar inflows. For the first six months of 1999, roughly $4 out of every $10 flowing into US equity funds have gone into index funds, up from just under $2 out of every $10 in the same period of 1998, according to Financial Research Corp. in Boston.

Meanwhile, Vanguard's Index 500 Fund, the second-largest US equity fund, is poised to sail to the No. 1 spot in the next few months, surpassing Fidelity Investments' Magellan Fund. Since the early 1980s, the Vanguard 500 fund has beaten the returns of over 80 percent of all US stock funds.

Moreover, dollars continue to pour into index funds, despite warnings from index-fund managers that returns may be lower in the months ahead.

Simply put, investors can't seem to live without them.

With an index fund "you will always equal" the market, says Sheldon Jacobs, who publishes the No-Load Fund Investor, a market report in Irvington-On-Hudson, N.Y. In an uncertain, roller-coaster market, the key is not to pull out of index funds, but to "make sure that you are in the right type of index fund," he says.

Mr. Jacobs recommends that investors be in a "total-market index fund," which is a fund linked to the Wilshire 5000 stock index.

The Wilshire 5000 is considered a proxy for the entire US stock market. Thus, a total-market fund gives you exposure to top industrial firms - companies linked to the S&P 500 - and the universe of small- and mid-cap stocks.

Most large fund companies offer total-market funds. Examples include Vanguard Total Stock Market Index Fund, T. Rowe Price Total Equity Market Index Fund, and Fidelity Spartan Total Market Index Fund.

While most index funds are geared to the S&P 500, only two major funds are linked to the Dow Jones Industrial Average, which contains 30 large blue-chip stocks. One, the ASM Index 30 Fund, is mired in controversy following a trading scandal. The other, the Strong Dow 30, is half indexed, and half actively managed in an effort to boost returns. As a result, the fund's expenses are higher than most other index funds.

More Dow-oriented funds are expected to be developed in the next few years, in part because the Dow is currently outpacing the S&P 500.

Today, investors have some 262 index funds to choose from, according to mutual-fund tracker, Morningstar Inc. Vanguard, which pioneered the concept in the 1970s, remains the industry leader, offering 18 funds tied to a variety of indexes including international markets, small-caps, and bond indexes.

Through July 16, 34 percent of all actively managed stock funds have beaten returns of index funds this year, a slightly higher percentage than in recent years. But look at the flip side: Roughly two-thirds of all managed funds were underperforming the indexes.

"Index funds should be a core holding in your portfolio," says Jacobs. That is, the index fund would become the bedrock around which other funds, which are actively managed, may be added.

Advantages of index funds

They're cheap. The average managed equity fund incurs expenses of about 1.5 percent. Vanguard charges 0.18 percent for its Index 500 fund.

They're stable. Because they are diversified, index funds may tend to do slightly better in down markets than managed funds do.

They're lightly taxed. Index funds have little turnover, so they produce fewer capital gains than actively managed funds do.

(c) Copyright 1999. The Christian Science Publishing Society