The popularity of index funds grew enormously in the bull market of the 1990s. Index funds are passively managed mutual funds that track a market index, the most popular of which is the S&P 500.

Index funds offer a low-cost way to make a market rate of return. They also are a hedge against the substantial risk of picking a bad manager—although your fund will do no better than the overall market, it will also do no worse.

That seemed like a great idea to many investors when the overall stock market was consistently churning out double-digit returns.

Earning an assured market return, however, has looked much less appealing to many investors over the last few years, when that assured rate of return has been a double-digit loss—particularly in comparison to a few actively managed funds that side-stepped any losses.

Is the index concept still a good idea?

Vanguard was the first major fund group to offer index funds to individual investors, and currently has the largest number of index fund offerings. In early March, Gus Sauter, managing director of Vanguard’s Quantitative Equity Group and portfolio manager for Vanguard’s line-up of stock index funds, discussed the index fund concept withMaria Crawford Scott.

Index funds have been criticized recently because it is perceived that they “didn’t work”—they suffered the full brunt of the bear, and didn’t avoid any of the excesses of the recent market bubble. In contrast, a number of actively managed value funds managed to avoid these big losses.

An index fund by definition is going to earn the market rate of return. It is not going to avoid market risk. In our view, the way to lower market risk is to be diversified—have a balanced portfolio that includes assets other than just stocks.

One problem is the focus on top performers. An index fund is unlikely to make it to the top of the list in terms of fund performance. But finishing first isn’t the point. I would argue that a stock index fund should outpace most fund managers because of its low costs and broad diversification.

We recently did a study, which since has been duplicated by Standard & Poor’s, that compares active stock fund managers with their stock market benchmarks. Using Morningstar’s nine-box matrix, we compared the average total return of actively managed funds in each of those nine categories with the relevant market index, and we calculated the percentage of funds that were outperformed by their benchmarks.

The results surprised even us. For 2002—clearly a bear market, with the S&P 500 down 22%—the indexes beat a majority of active funds in all categories except large-cap value and small-cap value. In the marquee match-up—the S&P 500 versus the large-cap blend—the index outpaced 59% of its peer fund group. And in the small-cap growth category, the index beat 95% of active managers!

We were surprised at the strong relative results for indexing because the time period was so short. The real advantage of indexing is lower costs, and that advantage grows as time periods get longer. In fact, when we did the same analysis over the five-year period ending December 2002, index funds performed even stronger relative to the active funds—even in the large-cap and small-cap value categories.

I look at everything as being relative to something else. I would say that the Total Market fund can’t be growth—the Total Market is everything. Other people might argue that it’s large-cap dominated. But by definition, it’s the total market.

Similarly, a frequent comment is that the S&P 500 became largely dominated by growth stocks in the late 1990s. But again, that’s looking at the world in absolutes instead of relatives. Yes, the average price-earnings ratio of the S&P 500 was 28 times, but does that mean everything in the index was growth? I don’t think so—there was a spectrum of really expensive stocks and lesser expensive stocks.

The same was true back in 1982 when the market bottomed. At that point in time, the average price-earnings ratio was 7.0. By today’s standards, the entire market was “value,” but once again there was a spectrum, and the highest price-earnings ratios were maybe 10.0 or 12.0 times earnings. So, I think you have to look at it as relative, and not as absolute, and if you do that, you can see that the market indexes really are a blend of growth and value.

Well, I would say that I wish I would have done that in the year 2000. But I’m not sure that I want to do it at this point in time. You certainly would not have wanted to do that in 1998.

While it is true that there are periods that favor value stocks, there are also periods that favor growth stocks. At this point in time, after such a huge run by value stocks, I’d be hesitant to assume that that phenomenon would go on forever. We know that at some point growth stocks will have their day—I don’t know if this is the point in time when they will, but then again, I don’t know that it isn’t this point in time, either.

The less risky path is to invest in the total market, or a blend, and not really bet on one segment or another. It’s easy to look back and pick a handful of funds that have beaten a relevant index in a given period. The difficulty—the risk—for investors is identifying those winners in advance. In fact, an investor is far more likely to select a fund that will substantially lag the market.

Yes. And all of the sudden today, everybody wants value funds. Of course, even there I think that a value index fund has the advantage over an actively managed value fund.

An equal-weighted index would have a heavier weighting toward the mid-cap and small-cap stocks than a market-cap-weighted index fund. But once again, that is taking a bet. In addition, the transaction costs associated with that approach would be much higher, and you’d lose one of the key advantages of indexing. A true index fund with weightings based on market capitalizations is self-balancing. And of course an equal-weighted fund would have higher tax costs associated with it.

Yes, that’s exactly right. The market is collectively what we can get. Any bet against that—anything that’s not market-weighted and not the entire market—is essentially a bet. It can be a value bet or a growth bet or a small-cap bet, but it is still a bet.

It does sound odd that we talk about diversification as being a very heavy weight in, for instance, General Electric, but you really have to view society’s investment opportunities as a big investment in GE.

Yes, we would agree with exactly what you said—any deviation from a total market index is a non-diversified bet against the market.

You could even say it more strongly than ‘unfortunate’—it was disastrous. In that situation, it was owned in the S&P 500 fund and obviously in the Total Market Index fund as well.

But the notion that index funds got clobbered by owning Enron—I like to point out that active investors took the same beating. About 10% of the U.S. marketplace is owned by index funds; the other 90% is owned by active investors, so in fact 90% of Enron was owned by active investors.

The advantage of a very broadly diversified index fund is that you minimize the exposure to Enron, you diversify a large portion of it away. In contrast, one active investor may have been lucky enough to have a zero weighting in it, but others had perhaps 2% of their holdings in it—or more.

An index fund isn’t going to avoid situations like that, but it’s not going to be overly weighted in those situations, either.

The presumption there is that those are less efficiently priced marketplaces and therefore there are more opportunities to add value. And I would agree with the premise that those segments of the market may be less efficiently priced.

However, the argument for indexing is not really based on the efficiency of the marketplace. Even in the small-cap and international markets, outperformance is a negative-sum game. Before costs, on average, half of all investors will do better than the market and the other half will do worse. But when you introduce costs into the equation, a majority of investors will underperform because the marginal outperformers before costs become underperformers after costs.

The real advantage of indexing is low cost, and it is an even greater advantage in those markets because the less-efficient markets are frequently the highest cost markets. Smaller-cap funds and international funds generally have both higher expense ratios and higher transaction costs than larger-cap funds. Our Small-Cap Index fund has an expense ratio of 0.27%, compared to 1.57% for the average actively managed small-cap fund. If you add up all of the costs associated with actively managed smaller- and mid-cap stocks, they can easily total more than 2%.

The data I mentioned earlier shows that indexing does work in small-cap markets, as well as in the European, Pacific and emerging markets. Investing costs are simply a higher handicap for active managers in those markets.

In the micro-cap area, where arguably there are some major inefficiencies, it’s very difficult—if not impossible—for a fund of any size to invest. Perhaps a very small fund can maneuver around and outperform, but once again, I think the best way to capture the micro-cap market is to index it. That way you really minimize costs, which are substantial in that segment of the market.

Yes, or invested in an index fund, although there aren’t a whole lot of micro-cap index funds to choose from. It’s very difficult—well, I’ll go out on a limb and say if you’ve got a $200 million fund it’s just impossible to actively manage a micro-cap fund. Micro caps are a portion of our Total Market and Extended Market funds, but we don’t have a separate fund for that segment.

Indexing is very tax efficient. Frequently, investors just look at the before-tax costs, at the return we get year-to-year without considering the fact that we might have to pay taxes on capital gains distributions. Given the turnover inherent in actively managed funds, typically an actively managed fund would have to outperform its relevant index by as much as 2% a year to get the same aftertax return.

The main point is, if you’re going to own actively managed funds, you ought to do it in tax-deferred vehicles.

That’s an interesting point. We’ve realized significant tax losses in our index funds, which we can’t distribute—you’re not allowed to distribute tax losses. So those will sit in the fund for up to eight years and essentially offset any capital gains that might be forced upon our funds. We have over $5 billion worth of losses in our S&P 500 portfolio right now, realized, and just sitting there. We look at it as a contingent liability that will ensure that we really don’t have to make any capital gains distributions for years to come.

Yes, you almost wonder why you’d want an IRA—just invest in an index fund and you get something that accrues totally tax free for years to come. And then when you take the money out of it, you’re paying capital gains rates as opposed to taking money out of an IRA at ordinary rates.

I think it is. There is some market impact that occurs, not just because of the index funds, but because of the concept of indexing. Hedge funds play a pretty good role in the price impact as well.

I would agree that there has been some short-term price impact, but I would also note that after the event, the stock price does tend to seek its true level again. It’s a short-term dislocation.