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Purportedly safe index funds can have volatility and high costs


HEDGE funds are hyperactive investment schemes popular in the high-rent district.

Index funds are passive, starter-home investments for the middle class.

Even Federal Reserve Chairman Alan Greenspan, a guru of free markets, warns of excesses in the hedge fund boom.

Index funds also are proliferating, as Wall Street exploits the presumably safe "index fund" label to hawk dubious products.

You can build a retirement nest egg with index funds. That's what President Bush intended when he proposed private Social Security accounts.

Many "hedge" funds do not actually hedge. And the merits of "index" funds require analysis, as well.

Experts debate the characteristics of the baskets that consist of indexes:

Most stock indexes are baskets of stocks weighted by the market value of the components. In the Standard & Poor's 500 index, for example, changes in General Electric's shares have a bigger effect than changes in General Mills' stock.

But market value depends on investor sentiment, not just intrinsic value. Robert Arnott, a fund manager and editor of the Financial Analysts Journal, says the S&P; 500 overweights overpriced stocks. Today's buyer of an S&P; 500 index fund is buying the irrational exuberance of yesterday's investor, he says. Chances of future gains are thereby diminished.

Gus Sauter, chief investment officer of Vanguard Group, which is known for its index funds, responds that market-cap weighted indexes simply represent the market. There's no reason to automatically disfavor popular larger-cap stocks, he said.

But if you own an S&P; 500 index fund, you might want to balance your portfolio with an index fund that doesn't hold the giant growth stocks.

Common stocks don't have expiration dates. Bonds expire after a stated life span. That characteristic makes it hard to maintain a bond index. With every day that passes, a long-term bond in an index is one day shorter. The government hasn't issued 30-year bonds since 2001. Long-term government bond indexes are less long term today.

"Their risk/return characteristics change," Joseph Benning, a senior economist at the Chicago Board of Trade, wrote in an article on the issue. Moreover, bonds tend to rise and fall in sync, unlike stocks, Benning noted.

Owning a few bonds with maturities targeted to your needs might be a wise complement to owning a bond index fund.

Indexes based on commodities or currencies sound like a good idea. But commodity and currency indexes are based on futures markets that may be thinly traded and highly volatile.

Such indexes can be dominated by one or two hot commodities, such as oil. You lose the goal of diversification.

But the biggest problem with funds that track commodity or currency indexes is cost. If the expense ratio of your index fund is more than 0.2 percent, you're paying too much. Some commodity and currency funds have expense ratios of more than 2 percent.

Compounding capital gains and interest income works beautifully, year after year. But compounding has the opposite effect regarding costs. Annual percentage fees drain more of your wealth over time.

Bill Barnhart is a columnist for the Chicago Tribune, a Tribune Publishing newspaper. E-mail him at your- money@tribune.com.

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