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Index Funds: Criticisms and Comments

The JofA received a number of letters regarding the two index find articles that ran in the January 2000 issue. These included letters from readers who pointed out errors in one of the articles as well as readers who took issue with some of the statements the authors made regarding index fund investing. Here is a sampling of positions taken. The author's reply follows the last letter on this subject.

I could not believe the article "Inscrutable Index Funds" (JofA, Jan. 00) was presented as fact. In addition to certain factual errors, it contained more subtle misrepresentations.

On page 31 in the paragraph beginning "Lack of sell discipline," the authors contend that actively managed mutual funds increase shareholder returns by selling stocks when they appear ripe to sell. If we call a spade a spade, this essentially says that mutual fund managers can successfully time the market--that is, pull money out when it is high and reinvest money when it is low. Only the most naive investor believes fund managers consistently succeed at this.

On page 25, the authors say the S&P 500 has consistently outperformed active managers from 1995 to 1998. While that statement is undeniably true, an uninformed reader might assume that prior to 1995, actively managed funds outperformed the S&P 500. Nothing could be further from the truth. From 1982 to 1998 the S&P 500 was in the top 50% of all general equity mutual funds 13 years out of the 17-year period. My source for this was the Vanguard S&P 500 annual report, confirmed by searching the Morningstar mutual fund service. For several of those 17 years, the S&P 500 was in the top 25% or better.

I am very disappointed in the JofA for allowing a slanted opinion piece like this to be presented as a factual article. My respect for the publication would be increased by some retraction or explanation.

Charles E. Schneider, CPA Minneapolis

I'm a bit confused about the information shown in exhibit 4, "S&P 500 Composition by Capitalization," of "Inscrutable Index Funds."

I am guessing that the chart, the source of which is shown as Invesco, is mislabeled. The chart title and the accompanying information claim that 90% of the investments of an S&P 500 index fund are in 10, mostly tech, companies. This is incorrect. I believe the chart actually shows the percentage of the S&P 500's return attributable to the 10 stocks over a relatively short period of recent time.

I hope JofA readers are knowledgeable enough about the S&P 500 index to disregard this incorrect information. For those less familiar with the specifics of this index, who may be tempted to change their investments partly based on the article, it's important to clear up some very misleading information.

Judy Shonborn, CPA Greenfield, Wisconsin

While there are truly good arguments to make against the S&P 500, how "Inscrutable Index Funds" became the cover story of the JofA I will never understand. In fact, I'm hot sure how it passed editorial review.

The suggestion that index funds are momentum plays because the funds indiscriminately buy larger positions in stocks of companies that are larger in size is incorrect. Index funds actually reduce the volatility of individual stock prices (vs. traditional active management) because they spread new investor monies around the stock market proportionately. Rather than throwing disproportionately large slugs of cash at small companies, which can easily alter market pricing, the funds are egalitarian, adding to individual stocks on a relative market-value basis. Thus, one would expect relative market caps to stay constant.

There is truth in the idea that new cash coming into the market can cause market momentum. That's why investors often look at trends in cash coming into or out of the marketplace. However, this is a macro issue unrelated to index investing.

Following the notion that index funds cause momentum stock buying, the article suggests that one should cut back or "rebalance" from winners to other, presumably, less winning names. Not only does this ignore the premise of long-term investing and the logic of keeping the relative values within a portfolio constant, it calls for the triggering of otherwise nicely deferred taxes. Paying tax with investment proceeds that could otherwise be compounding tax-free is a basic no-no that should be avoided.

To dispel any notion that I am an index fund groupie, I would like to offer what I believe are potential shortcomings of S&P 500 index funds:

* The S&P 500 is incomplete and/or behind the times. While stocks in the index are chosen by Standard and Poor to reflect broad economic currents flowing through the economy, some major names, especially in up-and-coming sectors, are absent from its ranks.

* Tax inefficiency. Many investors rightly diversify, owning mid-cap S&P 400 and large-cap S&P 500 indexes. The reality is that tax efficiency is lost when one begins segmenting groups of indexed equities, because growing companies are sold out of the S&P 400 mid-cap index with taxes paid on gains and then repurchased into the S&P 500 large cap index with bid-ask spreads and trading fees also incurred.

* Delay in reacting to changing market composition is also potentially costly to investors or at least creates tracking errors to the true "theoretical market basket." One example is initial public offerings (IPOs). The S&P makes no attempt to recognize IPOs when they occur, instead choosing to wait for some arbitrary future point to include large new public companies.

Darren A. Bramen Newtown Square, Pennsylvania

I enjoyed "Inscrutable Index Funds." It raises some valuable issues. However, there is a factual error and I have some minor quibbles.

Error: The composition of the S&P 500 index is no longer the 400/ 40/40/20 mix the article describes. These constraints existed prior to the mid-1980s, but no longer. For example, instead of the 40 financial stocks indicated, there are currently 71.

Quibbles: It is somewhat disingenuous to claim that "hidden dangers lurk" in passive investing. While this may be true, a poor match between investment policy and investment vehicles is a danger of any investment, not just index funds.

The sidebar about fiduciary responsibility seems narrowly focused on advisers to nonprofits. As CPAs provide investment advisory services to any client, they should realize they are acting as fiduciaries, whether the law specifies this or hot.

The authors' momentum investing argument is too strong. While it's true that capitalization-weighted indices inherently "up-weight" recent winners, index funds also benefited from the upswing. True momentum investors would chase recent winners. Index funds accept market capitalization as a measure of a company's relative worth; true momentum investors look to changes in price or capitalization as a measure of a company's future prospects.

There is little evidence that actively managed portfolios successfully overcome the negatives you attribute to index funds: Contrarian strategies do hot consistently beat momentum. More (or less) diversified portfolios do not inherently beat the index benchmark consistently. Whether growth dominates value is an open question. Sell discipline and down-market performance do not necessarily cause active funds to beat indices.

The second index funds article, "The Quest to Outperform" (JofA, Jan.00) addresses some of these issues. The two articles forma nice package. Each adds invaluably to CPAs' discourse on investments.

William W. Jennings, CPA, PhD, CFA Colorado Springs, Colorado

For those interested in the benefits of passive investing (see "Inscrutable Index Funds"), it is worth pointing out another passively managed alternative to index mutual funds.

Exchange-traded index tracking stocks (commonly known as Spiders, Diamonds and Webs) can provide investors with low cost, diversified exposure to a number of popular domestic and international indices or market sectors. These investments have advantages over index mutual funds in that they can be traded like stocks (priced and traded intraday, sold short or purchased on margin), have low purchase minimums and, most important, put investors in control of their tax exposure.

From a portfolio strategy perspective, the index tracking stocks available today allow investors more flexibility than index funds to build balanced portfolios around their own individual circumstances and objectives. For instance, investors may want to hedge or offset a particular exposure, such as a large holding in their company's stock, by maintaining nonindex weightings in particular sectors.

Because of the market's rapid acceptance of index tracking stocks, it is likely investors will have more such options to consider in the future.

Timothy C. Burns, CPA, CFA CIGNA Investment Management Hartford, Connecticut

The authors respond to readers' comments:

Many readers recognized that exhibit 4, the pie chart on page 31, was labeled incorrectly. We apologize for this error. The chart, in fact, describes the degree of contribution the 10 largest stocks made to the total return of the S&P 500 index for the 9 months ending September 30, 1999. As of that date, those 10 stocks, which represented 2% of the 500 issues in the index, provided about 20% of the index's market value.

The exhibit on page 25, "Sample S&P 500 Index Fund Returns," was also incorrect in showing two different periods of time for comparison, thereby omitting Vanguard's higher rate of return (16.672%). We apologize to readers and to Vanguard for this error.

Passive vs. active investment was the area of greatest feedback from readers. Our probing into the nature of passive investments should not be interpreted as veiled advocacy of market timing--rather, our goal was to alert readers to the risks inherent in a philosophy that does not employ the tools of fundamental analysis.

We agree the sidebar on fiduciary responsibility was too narrowly focused on tax-exempt organizations. A CPA who provides investment advisory services to any client, in fact, must exercise fiduciary responsibility.

We thank the readers who appreciated our article collectively with "The Quest to Outperform" as point and counterpoint on index fund investing. It was the JofA's intent to contribute to CPAs' discourse on investment topics.

Mark Johnson, CIMA Laura A. Collins, CPA Greensboro, North Carolina

Thinks HMOs Wrongfully Blamed

I was disappointed that the article "Managing the Cash Gap" (JofA, Oct.99) was allowed to be published with such a blatant, unsubstantiated slam against the HMO industry. The statement that "some health care providers can have 60 to 90 days in receivables, thanks to slow-paying HMOs that actively manage their cash gaps by delaying payments" is uncalled for in a professional publication. We all know that HMOs have become the media's favorite whipping boy now that other favorites like the tobacco industry are in disarray, but I don't expect that behavior from the JofA.

I have been involved in HMOs for over 10 years. While there no doubt are some bad apples out there, every HMO I have been involved in has worked hard to get claims paid as quickly as possible. Any additional interest earned on cash flow is not worth the member service and provider service headaches and increased administrative costs due to higher call volumes, member and provider dissatisfaction, and so forth, that result from deliberately slowing claims payments.

Bill Scheerer, CPA Atlanta

More About the Commerce Clause

Thank you for publishing the summary of the Alabama franchise tax decision ("For Whom the South Central Bell Tolls," JofA, Jan.00). I would like to draw more attention to the burden that states place on individuals who perform services in multiple states.

In more than 20 states and various localities, there is currently no de minimis for exempting wages from withholding when services are performed. I have clients with $25,000 in wages who have withholding in 24 different states and 4 localities. The rule is that personal services are subject to withholding in the location where the services are performed. The unemployment wage base is replicated in each state, and compliance is a nightmare.

Since the cost of filing outweighs the benefit of a refund, most states collect more than the legal amount due. Surely this is what the Commerce Clause was intended to discourage.

Lyn F. Richards, CPA Columbia, South Carolina

Readers Find Technology Workshops Helpful

I just have to applaud you on the Technology Workshop series in the JofA. For three months in a row, the topics have been timely (for example, the Excel Pivot Table/Access tie-in, Auto Filter, Conditional Formatting).

Could I suggest covering macros, buttons and visual basic for automating purposes?

Scott Wallace, Accounting Instructor Blue Mountain Community College Pendleton, Oregon

I've been a member of the AICPA for longer than I'd like to think, so I've received a lot of issues of the JofA.

The "Spreadsheet Smarts" article (JofA, Jan.00) was one of the easiest to follow, most practical and beneficial I've read throughout the years. I came to work this morning, went through each of the three spreadsheet functions covered and was amazed at the results. Unfortunately, it's true that most of us barely scratch the surface when it comes to using the many built-in tools in Microsoft Office products.

This article will be passed around to everyone in my company's finance department to provide them with the opportunity to improve the functionality and efficiency of their many spreadsheets.


Gail Millward, CPA Reno, Nevada

I appreciate the variety of articles in the JofA, particularly "Spreadsheet Smarts." I find such articles very useful in training others as well as myself.

Spreadsheets have many labor- and time-saving functions of which many professionals are hot aware. I would greatly appreciate it if, in the near future, you could include an article focusing on developing and maintaining graphs and shortcuts related to this.

Roger G. Bobo, CPA Murfreesboro, Tennessee

Letters to the Editor

The opinions and views expressed are those of the letter writers and do not necessarily reflect those of the AICPA.

The JofA encourages readers to write letters on important professional issues in addition to comments on published articles. Because space is limited, letters submitted for publication should be no longer than 500 words. Please include telephone and fax numbers.
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Publication:Journal of Accountancy
Date:Apr 1, 2000
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