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Index Funds Appear to Remain Strong

If S&P 500 index funds are beating 90 percent of the mutual funds available, why are fund companies creating so-called "enhanced" mutual funds? Does it mean that index funds are not cutting it any more in a market where Internet funds are returning over 100 percent?

According to fund executives and brokers, "enhanced" index funds - index funds that try to beat the index they follow - are not being created to replace pure index funds. Rather they are being created to offer investors a new and different product.

Scudder Kemper Investments of New York, for example, recently started two enhanced index funds, the Scudder Select 500 Fund and the Scudder Select 1000 Growth Fund. The two funds seek to beat their indexes, the S&P 500 and the Russell 100 Growth Index, respectively. And, Bankers Trust Corp. of New York has recently started offering advisors its first enhanced index fund. Its Quantitative Equity Fund follows the S&P 500 but also attempts to take advantage of merger activity to outperform that index.

The new fund was not created specifically because advisors were asking for a product that could outperform the S&P 500, said Ray DeAngelo, vice president and director of advisory at Bankers Trust. Rather, Bankers Trust took an institutional account called the BT Pyramid Quantitative Merger Arbitrage Fund with a good track record and turned it into a mutual fund. The company believes that some customers are attracted to funds with complex strategies like that of this fund. It seeks to invest in companies that are likely to be acquisition targets. These investments are made on the basis of a proprietary quantitative model.

Bankers Trust, meanwhile, remains committed to pure indexing on the institutional and retail side, and it believes indexing is an investing style that will continue to be popular, DeAngelo said.

So does Scott Leonard, a fee-only advisor from Santa Monica, Calif. Leonard uses index funds for many of his clients as part of a "passive" management strategy. Enhanced index funds are only one product that can be used in a diversified passively-managed portfolio, he said.

Although he does not think that indexing is out of style, Leonard says some people who had been in indexes have been caught up by the performance of Internet funds and abandoned indexing at least for the time being. These retail investors probably had no clear index strategy when they invested in index funds to begin with, Leonard said.

"If money's moving other places, I think it's because people are chasing hot stuff. Maybe they're leaving some of their index stuff for that," Leonard said.

Investors are increasingly putting their money into index funds, however, according to Financial Research Corp. of Boston. While in 1990, only one percent of all mutual fund assets was in index funds, that number had risen to 6.6 percent by the end of 1998, according to FRC. Net sales for 1990 were $2 billion. Net sales in 1998 were $42 billion. Net sales through February of this year have been $14.9 billion compared with $7.6 billion for the same period last year.

Of those sales, in 1999, 66 percent was invested in S&P 500 index funds. In 1998, 65 percent was invested in S&P index funds.

"Index funds are tremendously popular right now," said David Haywood, an analyst at FRC.

Paul S. Seibert Jr., a fee-only advisor from Asset Management Associates in Lincoln, R.I., claims that by the year 2005, 15 to 20 percent of all mutual fund assets will be in index funds. However popular they may be with investors, he does believe that their performance may be fueled by the fund industry itself.

"I do have a short range concern about index funds in that they are reflecting more and more the huge buys that the managed funds are making in the small group of stocks which account for most of the DJA run-up," Seibert said by e-mail. For this reason, he is encouraging his clients to diversify out of index funds. However, he said no clients are coming to him asking to lighten up their investments in indexes.

There are in fact indications that many investors are heeding this message.

The Vangaurd Group of Valley Forge, Pa., for example, has noticed a growing interest in index diversification, said Brian Mattes, a principal with the firm.

Net flows into Vanguard's 500 Index Fund, which follows the S&P 500 Index, and the Vanguard Total Stock Market Index Fund, which follows the Wilshire 5000 Index, were up the first quarter of 1999 over last year's first quarter.

However, the rate of increase was greater in the Total Stock Market Index Fund, which is making Vanguard officials believe retail investors are diversifying out of the S&P 500 index.

"That's an enormous sign," Mattes said.

The Vanguard 500 Index Fund had $82.6 billion under management as of March. The Vanguard Total Stock Market Index Fund had $10.7 billion under management.