New Appeal of Index Funds May Give Mutuals a Scare.

HARDLY a week goes by without a new "exchange-traded fund," or index stock, getting introduced on Wall Street. Back in June, the index stock with the symbol "VTF" became listed on the American Stock Exchange. The stock VTF is based upon the stocks found in the Wilshire 5000 index (from Santa Monica-based Wilshire Associates), considered one of the broadest measures of the U.S. equities market.

For individual investors, index stocks can be very appealing. By buying a single stock, such as "SPY" (which comprises Standard & Poor's 500 index) an investor can achieve a world of diversity, yet pay minimal management fees. Most index stocks charge just about 15 basis points (0.15 percent) in fees, vs. 1 percent to 3 percent for mutual funds, noted Roy Weitz, publisher of fundalarm.com and a San Fernando Valley resident.

Such index stocks can be bought easily on the Web through a discount brokerage, thus trimming investor transactional costs to the bone.

Index stocks have other advantages too -- instant liquidity when the exchanges are open, and no capital gains taxes until the stock is sold. In a mutual fund, investors have to pay capital gains on those portions of the portfolio profitably liquidated in the year, even if they have not sold their mutual fund shares.

Then there's that nettlesome problem for market professionals: No mutual fund manager, or any Wall Street guru for that matter, seems able to consistently outperform the market. Indexing (as many pension funds have found out) makes a lot of sense.

But don't rule out mutual funds yet, said Weitz. Millions of investors have sunk their nest eggs into mutual funds,, and the industry advertises heavily. In what is perhaps an analogy, discount brokerages did not wipe out the full-service brokerages -- although consolidation and pressures on brokerages to become more efficient were magnified, said Weitz. But the strong survived.

"I think we will see mutual funds become more efficient, lower costs, start paying some attention to tax issues, and we will see consolidation.

"There are way too many funds," he said. "But the funds won't be dethroned overnight."

And as there are so many funds, some will always outperform the market for a while -- and will be able to tout those returns (even if they are generally fleeting) to garner new deposits.

Weitz conceded the mutual fund industry is "vulnerable," for two disparate reasons. First, some financial advisers, such as independent certified financial planners, are embracing index stocks and recommending them to clients, for their obvious attributes. That may spur ordinary investors to hasten their acceptance of the new instruments, which have become generally known only in the past couple of years.

Second, baby boomers may be ready to step back from Wail Street, said Weitz. "You know, as people get closer to retirement, they want to take less risks, not more," he said. Throughout the 1970s, many investors stayed in money market funds, noted Weitz. "Five percent a year (in interest) might not look so bad, if the Dow is up 2 (percent) then down 5 (percent)," he said.

Contributing columnist Benjamin Mark Cole writes about the local investment community for the Los Angeles Business Journal. His new book is "The Pied Pipers of Wall Street: How Analysts Sell You Down the River," published by Bloomberg Press.