INDEX funds, for all their simplicity, have become one of the red-hot investments of the 1990s.
These funds, designed to follow a benchmark such as the Standard & Poor's 500 stocks, helped propel the Vanguard Group to its position as the No. 2 mutual-fund company, behind only Fidelity Investments in assets under management.
Index funds consistently outperform about three-fourths of all actively managed funds in their peer groups. A key reason: With virtually no management costs, these funds have the lowest service fees in the industry.
Now, success is prompting imitation - and variety.
Merrill Lynch & Co., for example, has just filed papers with the US Securities and Exchange Commission for four new index mutual funds. The funds, which have not yet been approved by the SEC, will be aimed at specific types of investors, such as those who have 401(k) retirement accounts.
Of 125 index funds tracked by the rating service Morningstar Inc., 39 have been developed in just the past three years. Most index funds are offered by smaller fund families, though larger firms such as Merrill Lynch are climbing on the bandwagon.
Branching out from tried-and-true S&P 500 funds, many companies are offering funds that follow less-familiar indexes, including those for bonds and overseas stocks.
Vanguard remains the leader in the field. It offers a roster of 20 index funds (most shown in chart, right), totaling more than $55 billion in assets, as well as actively managed funds.
Vanguard has index funds following emerging-market stocks, US bonds, and even a pair of funds that subdivide the S&P 500: One buys the S&P stocks that match a "growth" style of investing; the other buys the S&P's "value" stocks.
Vanguard's plain old Index 500 fund, which mirrors the S&P 500, is America's third-largest mutual fund, with $27 billion in assets. Assets for that fund are up $10 billion so far this year, from about $17 billion on Jan. 1.
Meanwhile, another company has created a "socially responsible" version of an S&P 500 fund. The Domini Social Index Fund, which excludes tobacco and defense stocks among others, is up 15.8 percent this year, as of Oct. 31. That compares with a 14.5 percent return for the S&P 500.
How much exposure should an average investor have to index funds? A Vanguard spokesman says at least 60 to 70 percent, with the rest in managed funds. Many analysts say that amount is high. Some recommend no more than 50 percent (or even less), with substantial assets kept in "active" funds, where a fund manager picks investments day by day.
The issue is partly philosophical: If you want to be assured of having fairly average performance, analysts say an emphasis on index funds is appropriate. If you don't want to miss the chance to reap superior, market-beating returns, managed funds are for you.
Index funds have an element of "reliability in terms of their investment strategy," says Alice Lowenstein, an analyst at Morningstar in Chicago. Their objective is usually not to "beat" the market but to "equal" it. When the index rises in a bull market, the fund rises by about the same amount as the index. Conversely, when the index drops, the fund will similarly decline, unless its operating rules have some built-in check-points to inhibit a decline, such as allowing fund officials to move to a larger "cash" position.
This last point is relevant today. Recent statistics show US economic growth slowing substantially from earlier in the year. As a result, some actively managed funds are now shoring up the "defensive" position of their portfolios in case the market were to decline. Index funds cannot typically do that.
"The problem [with index funds] is, what happens when the market starts to slide?" asks one Washington-based mutual-fund analyst. "If you've got your life savings in index funds, a rapid market decline could literally wipe you out very quickly," he says, exaggerating.
Index funds may, indeed, do badly in down markets. But defenders argue that, since the long-term trend of the market is up, index funds are ideal for small investors over many years, despite the bumpy ride.
Index funds consistently have the lowest overall operating expenses in the industry, says a spokesman for the Investment Company Institute, a mutual-fund trade group in Washington.
Vanguard's Index 500 fund, for example, has annual expenses of about 0.2 percent of assets, compared with about 1.4 percent expenses on a typical equity fund.
The cost advantage can be particularly valuable in the bond market, where profit margins are often narrow, Ms. Lowenstein says.
In addition to low expenses, index funds offer a tidy little tax advantage. Since fewer "trades" are made in the fund's portfolio, there are fewer capital-gains distributions to pay taxes on than in managed funds. This advantage is useful if the fund is not held in a tax-deferred retirement account.