Happy birthday . . . index funds!

One of the more popular market investments, index funds, just turned 30.

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KAI RYSSDAL: If you've ever forgotten a friend's birthday you know just how we feel. It's an occasion we should have marked. So our heartfelt apologies to the Index Fund. The Vanguard First Investment Trust turned the big 3-0 last month. Back in the mid-'70s it became the first index mutual fund marketed to small investors. It's now called the Vanguard 500 Index Fund.

Vanguard started quite a trend. There are more than a thousand investment opportunities out there called Index Funds. They're not the only ones celebrating a birthday. Marketplace's Jeff Tyler marked his this week. We asked him to size up his fellow Virgo. Jeff, in turn, recruited a ringer from New England's Big E County Fair.

JEFF TYLER: For five bucks, Ian Rafuse will guess your age, weight or birthday month.

RAFUSE: "I'm guessing your age within two years, your weight is three pounds, your birth month guess within two months. If I'm wrong, you pick it out. It's any prize you like, come on in now."

Handed a prospectus for the Vanguard 500 Index Fund, Rafuse hazarded . . .

RAFUSE: "Well um. I don't really know much about it. But I'd say probably seven years."

Out of three questions, the professional guesser was wrong three times. The Vanguard 500 Index Fund is 30 years old.

The weight? Well, that was a trick question. I'll get back to that. And the third, Rafuse admits . . .

RAFUSE: "The birthday month is just a random guess. Just got to pick a month, and hopefully it's the right one."

Some argue that mutual fund managers, though more sophisticated, are essentially glorified guessers.

At Vanguard, the birthplace of the index fund, Paul Lohrey looks after some $400 billion by applying a simple philosophy.

PAUL LOHREY: "Don't guess. And don't spend the money it takes to have someone smart try to figure it out for you."

Even the pros get it wrong. According to statistics, Lohrey says, professional fund managers are wrong often enough that the investor does better by cutting out the guesser.

LOHREY: "In contrast to that, in an index fund, you don't try to make any judgment value, you don't try to figure out which stocks will out-perform. You just simply invest in the stocks in the index."

Instead of trying to beat the market, the index fund investor is content to match the market.

So when the S&P 500 index rose 3 percent last year, then, roughly speaking, so did your S&P 500 Index Fund. But it's the savings that really make the index fund attractive.

So says Jeff Tjornehoj, a senior research analyst with Lipper.

JEFF TJORNEHOJ: "So the index funds win hands down when it comes to talking about the price of their product."

An actively managed fund may charge one to two percent for its services. Index funds cost more like two-tenths percent. Over the years, those fractions add up, making it even harder for fund managers to earn their keep.

Of course, index funds have flaws too.

For example, Tjornehoj says, index funds are often adjusted quarterly or even annually, making it harder to dump a loser.

TJORNEHOJ: "Index funds have to follow their benchmarks. So if they are holding, say, an Enron or a Worldcom, they're usually holding it until it's pulled out of the index, and that may not happen until the stock has really bottomed out."

And then there's the issue of picking which stocks to include in the index.

TJORNEHOJ: "Somebody has to make a decision, introduces a small amount of bias."

That issue of bias brings us back around to the question of weight. When asked the weight of the Vanguard 500 Index Fund, Ian Rafuse guessed . . .

RAFUSE: "It's all lumped together. Just all in . . . altogether as one."

No. In fact, the traditional metric has been market capitalization. That's the total number of a company's shares multiplied by its stock's price.

In recent years, that standard has been challenged. Other models weigh the fundamentals, which is to say a company's total sales, for example. Or the size of its workforce. Still another system distributes weight evenly assigning each company an equal value in the index.

When asked to choose, Ian Rafuse went with . . .

RAFUSE: "I would pick all equal weight."

Is he wrong? Is the traditional market-cap model better than the equally weighted index? Tjornahoj says not necessarily.

TJORNEHOJ: "I don't think either one is as flawed as buying an overpriced mutual fund."

Unless you like overpriced mutual funds. After all, some folks enjoy shelling out $5 for a chance to beat the guesser out of a two-bit panda.

Wishing I were at the fair, I'm Jeff Tyler for Marketplace Money.

About the author

Jeff Tyler is a reporter for Marketplace’s Los Angeles bureau, where he reports on issues related to immigration and Latin America.

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