STOP BAD-MOUTHING THE INDEX FUNDS!

By Daniel Kadlec

It's hard to imagine controversy over stock-index funds, investments so sensible and pure that they are practically motherhood on Wall Street. The problem, it seems, is that this particular mother has consumed a few too many bonbons and grown to a crushing weight. Money has been flowing into stock-index funds in torrents in recent years as investors have caught on to their appeal: index funds cost little to run, compared to actively managed funds, so more of the profits are passed on to investors. Index funds are also easy to track since they move in near perfect tandem with popular indexes such as the Dow Jones industrial average or the Standard & Poor's 500. And for three years running, returns on the index funds have trounced that of the average stock fund. No wonder assets in stock-index funds have increased tenfold in five years.

Just what is index investing? Nothing more than buying all the stocks that make up an index in an effort to replicate in your own portfolio the index's gains or losses. Now some market analysts are finding an insidious side to this seemingly logical procedure. The knock is that index funds are a perpetual investment machine, mindlessly buying the stocks that constitute the index, so as cash rolls in, the index moves higher, without regard for the prices being paid. Critics say the Dow Jones industrial average, which passed 8000 last week, did so well ahead of its rightful time in part because index funds (Dow stocks are in the big ones) are getting so much money to invest. Their conclusion: the indexes have become bloated with overpriced stocks and can't help getting hit hardest when the market inevitably turns down.

I don't buy it. Not all of it, anyway. Sure, the indexes are bloated. Anybody can see that. But don't blame the index funds. It's part of a mania that has bloated the entire market. There's good reason to be worried about a steep correction that would hit all stocks. So stick your money in a mattress if you're worried. But if you are committed to owning stocks for the long haul, indexing still makes sense. For one thing, there is scant evidence that major indexes fall harder than most stock funds. In 1987, the year of the crash, the S&P 500 did better than 76% of general stock funds. In 1990, the last year stocks were down, the S&P 500 outperformed 64% of general stock funds. Secondly, there are now dozens of choices in index funds. You don't have to buy just the S&P 500, by far the most popular and thus worrisome in the index world. There are index funds for the broad market (Wilshire 5000), small companies (Russell 2000 and S&P 600), mid-size companies (S&P 400) and overseas companies (Morgan Stanley International). Any of those offer cover should the S&P 500 tumble hardest.

About 75% of the money in stock-index mutual funds is tied to the S&P 500. The biggest of those funds, the Vanguard Index 500, has $44 billion and is rapidly closing in on the nation's biggest stock fund, Fidelity Magellan ($58 billion), which is not an index fund. Stock-index mutual funds are only a small part of the story, though. Pension-fund managers have been indexing for two decades to ensure that they earn a market rate of return. They have some $600 billion to $700 billion tied to the S&P 500.

It's a giant pot of money. "But this is not the tail wagging the dog," insists Frank Salerno, a managing director in charge of index funds at Bankers Trust. Index funds, including the big pension money, account for only 10% of all the money invested in S&P 500 companies. It's unlikely that such a small percentage is dominating the index. The other 90%, which presumably has made reasoned judgments about value, has a lot more to say about where the S&P 500 is going. Yes, prices relative to earnings on big stocks like General Electric and Coca-Cola are the highest they've ever been. That smacks of mindless index buying, not buying based on value. But Blu Putnam, president of CDC Investments, a money-management firm, notes that blue chips deserve the high P/Es because they have doubled their rate of earnings growth over the past five years. That makes them more attractive relative to the rest of the market, which hasn't seen the same growth.

So maybe it really is the active money managers--that other 90%--pushing up the price of blue chips, and for what passes as good reason. If so, it doesn't necessarily follow that stocks in the S&P 500 are especially vulnerable. I'm not saying this is the time to buy an S&P 500 index fund. I would be wary of all stocks at current levels, and if I were desperate to buy something, I'd probably choose a road slightly less traveled, say a small-company or overseas index fund. But I certainly wouldn't ditch my S&P 500 fund--which has minted gold for three years and may mint a lot more before it's exhausted--on the faulty logic that what goes up highest must come down hardest.

Daniel Kadlec can be reached online at kadlec@time.com