Once the playing field of defined benefit plans and other institutional investors, passive funds finally have the attention of defined contribution plan and retail investors in 1996, attracting nearly $25 billion from those investors.
Attracted by Standard & Poor's 500 returns of 22.96% in 1996 and 37.58% in 1995, investments into indexed equity mutual funds by defined contribution and retail investors accounted for 5% of the $450 billion of new cash that went into all equity funds last year, according to data from Strategic Insight Mutual Fund Research and Consulting L.L.C., New York. S&P 500 index funds attracted most of the new money, said Avi Nachmany, director of research.
But many observers caution much of the growth last year in indexed funds probably represents "hot money" from retail investors focused on short-term investment performance, rather than long-term asset allocation.
"As soon as the S&P 500 begins any kind of prolonged slowdown in growth, retail investors are likely to take their money over to the next hot performing class of funds," said one mutual fund consultant.
And despite the spurt in asset growth in 1996, some observers put the trend into perspective.
"The $88 billion in equity and fixed-income mutual funds is just 4% of the total of $2 trillion invested in mutual funds overall. I wouldn't describe this movement into index mutual funds as anything to get hysterical about," said Henry Shilling, a senior vice president and senior analyst at Moody's Investors Service, New York. Mr. Shilling said he only included funds that apply strict indexing mandates to investment in his estimate of the market share held by passive equity mutual funds.
Other observers see investment in indexed mutual funds as largely cyclical, fueled by investors chasing performance of the S&P 500.
J. Gary Burkhead, president of Fidelity Management & Research, Boston, pointed out that over the last three years, the S&P 100 has significantly outperformed the rest of the S&P 500, creating a very narrow market.
"When you have a relatively small number of companies in the S&P accounting for so much of the S&P's overall return, the market significantly narrows. It becomes very difficult for active managers to outperform the index in a narrow market; active managers always do better when the equity market is broader," said Mr. Burkhead.
"This has happened three or four times over the past 20 years and I think it will happen again, with indexers likely to lose their performance edge once the market broadens out, as it inevitably does. I really think that indexing is cyclical, dependent on market breadth."
Data from Morningstar Inc., Chicago, showed retail investors held about $55 billion in indexed mutual funds as of Nov. 30, compared with $35.5 billion at year-end 1995. Institutional investment in indexed mutual funds still lagged significantly behind the retail portion with $30 billion at the end of November, compared with $20.2 billion at the end of 1995.
The shift by individual investors to indexed mutual funds is part of a "real '90's phenomenon," said John Shields, a consultant at Cerulli Associates Inc., Boston. "Indexing is just beginning to become very sought after, especially in the form of mutual funds, pushed by both retail and institutional investors. The real growth in indexing for individual investors has taken place since 1992 and 1993, when investors began to get access to institutional-style investment through mutual funds offered in the no-transaction-fee supermarkets like (Charles) Schwab (Co.)," said Mr. Shields.
Data from Lipper Analytical Services Inc., New York, found that lately, most retail investors bought indexed equity fund shares directly from the mutual fund company, rather through brokers, mutual fund supermarkets or financial advisers. Assets of retail mutual funds sold directly by a company shot up 75% to $34.4 billion in 1996, compared with $19.7 billion the previous year, according to Lipper data. Such assets are most vulnerable to transfers should the S&P 500 suffer a protracted downturn, said Cerulli's Mr. Shields.
Even a mostly institutional manager, State Street Global Advisors, Boston, enjoyed growth from retail investment in its S&P 500 Index Fund in 1996. Retail investors put about $50 million into the indexed equity fund last year, having found the fund by themselves, because SSgA didn't advertise the fund at all and didn't stress any broker distribution channels, said Gus Fish, principal. The fund also enjoyed great gains from 401(k) plan investors, said Mr. Fish, growing to $903 million at year-end 1996 from $532 million at the end of 1995. About 46% of total assets were from defined contribution plan investors in 1996.
The Vanguard Group of Investment Cos., Malvern, Pa., the market leader that manages about two-thirds of all indexed mutual fund assets, mostly in its retail S&P Index 500 and the Institutional Index Fund, saw much higher growth in retail investment in 1996 than in typical years, said William McNabb, senior vice president-institutional. About 65% of new cash flow into the S&P 500 fund was from retail investors, compared with about 50% in a typical year.
Mr. McNabb said Vanguard has been trying to educate retail investors that index funds are subject to market movements. "It's unfortunate, but many people are focusing on short-term performance, rather than on long-term allocations. We want people to buy these funds for the right reasons," he said.
But individuals aren't the only investors who appear to be chasing short-term performance. Mr. McNabb said Vanguard had a big in-flow of money from institutional investors, primarily from by endowments, foundations and defined benefit plans.
"Some of those institutions seem to be very focused on three-and five-year returns, rather than on the long-term asset allocation of their funds. I suspect we are seeing some money flowing into our institutional index fund which has come as a result of reviewing existing managers' three-year returns. When an investment committee looks for a replacement manager, it may be natural that they are looking at the three-year returns of the S&P 500 and making a decision based on that performance," Mr. McNabb said.
A new surge in interest in the use of indexed commingled funds as core 401(k) plan options by large defined contribution plans already has begun to move billions of defined contribution plan assets out of mutual funds. Led by giant plans such as those sponsored by Eastman Kodak Co. and Boeing Co., large defined contribution plan sponsors are being driven by an awareness of fees and a need for better investment style purity to look seriously at commingled indexed funds.
State Street Global Advisors gained between $15 billion and $20 billion in commingled index fund business last year alone from large defined contribution plan sponsors, said Philip Lussier, principal. SSgA attracted about half of that amount to passive commingled funds in 1995.
"We hear that most plan sponsors with over $100 million in plan assets are beginning to ask questions about commingled funds. The drivers are consistency of investment management and style purity and much greater fee awareness. Virtually every RFP out there is asking for information on non-mutual fund indexed funds. The demand is huge," said Mr. Lussier.