Go with the flow.
That's the logic behind an index fund. Rather than getting fussy with individual stock picks, this increasingly popular instrument seeks to replicate performance of a particular market index by buying representative stocks.
Computers make the process happen.
Individual investors are jumping on the indexing bandwagon as they seek to diversify holdings. So are large pension funds disgruntled by the fact that only a select portion of portfolio managers consistently beat the market averages.
About $270 billion in financial assets are now in index funds and one-third of all institutional holdings are indexed.
An indexing pioneer was William Fouse of Wells Fargo Bank, who put together a fund based on a composite of stocks on the New York Stock Exchange for the Samsonite pension fund in 1971.
Correlation of a fund to the actual index varies depending on methods used. There's seldom an exact one-for-one link between stocks in the index and those in the fund.
"An index fund is designed to mimic risk-and-return characteristics of a particular benchmark, but because of different weightings and procedures, there can be differences in performance," said Dan Cooper, professor of finance at Marist College, Poughkeepsie, N.Y.
Complicating matters, there are "enhanced" index funds that put a portion of a portfolio into options, primarily to limit downside risk.
"If asset allocation is of primary importance, index funds present an excellent way to allocate yourself across a mixed group of asset classes," Cooper emphasized.
To be effective, it's important to minimize management fees and structural costs and to have modest portfolio turnover.
"The Vanguard Group has a clear advantage because it doesn't take profits as other funds do, but simply pays managers and basic administrative fees and recycles all the extra costs back into the fund," said Cebra Graves, analyst with the Morningstar Mutual Funds investment advisory. "People at Vanguard get into the minutiae of reducing expenses."
Vanguard has 15 index funds available to the public, the most popular one the Vanguard Index 500 portfolio started in 1976.
"A common thread is that they're, in effect, managed by computers, which make the buy and sell recommendations," said Gus Sauter, port folio manager of Vanguard equity index funds.
While in some cases there's a sampling process that selects a similar number of small- and large-capitalization stocks as held by the index, some index funds are more exotic.
"About 5 percent of our fund is tied up in S&P; 500 futures contracts and equity swap contracts as we try to beat the S&P; by 8 percent over the life of the fund, which we've been able to do," said John Sprow, portfolio manager for Smith Breeden Market Tracking Fund.
Here are top-performing index funds vs. comparable market indexes:
* Vanguard Index 500 Fund, up 25.92 percent for the 12-month period through the end of July, compared to 26.06 percent for the S&P; 500 for that period. This $14 billion "no-load" (no initial sales charge) fund in Valley Forge, Pa., requires a $3,000 minimum investment and has an annual expense ratio of 0.19 percent (vs. a 1.38 percent industrywide average for stock funds).
* People's S&P; MidCap Index Fund, up 24.56 percent over 12 months compared with 24.46 percent for the S&P; MidCap 400.
This $122 million no-load fund in New York requires $2,500 and has an expense ratio of 0.40 percent.
* Dreyfus Wilshire Target Small Company Growth Fund, up 33.85 percent over 12 months vs. 26.11 percent for the Wilshire 5000. This $22 million no-load fund in New York requires $2,500 and has an expense ratio of 0.74 percent.
* Vanguard International Equity Index European Fund, up 19.13 percent over 12 months vs. 6.97 percent for the Morgan Stanley Capital International Europe/Australia/Far East Index. This $890 million fund with a 1 percent load requires $3,000 and has an expense ratio of 0.32 percent.
* Enhanced index fund Smith Breeden Market Tracking Fund, up 28.74 percent over 12 months vs. 26.06 percent for the S&P; 500. This $2.7 million no-load fund in Chapel Hill, N.C., requires $1,000 and has an expense ratio of 0.40 percent.