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Are mutual fund managers becoming obsolete?

That's a question many investors are bound to ask because of the eye-popping returns produced the last four years by mutual funds that simply mimic popular stock market indexes like the Standard & Poor's 500.

Last year, for example, just 10 percent of all general equity mutual funds managed to do better than the S&P 500, which was the worst performance by stock fund managers in the last 27 years, according to statistics compiled by David L. Babson & Co.

And over the last four years, less than a quarter of all domestic stock funds have beaten the S&P 500, which begs the question: Why invest in anything other than an S&P 500 index fund?

That's a tempting approach, which is part of the reason why investors had $152 billion stashed away in index funds at the end of last year, up 177 percent from two years ago, according to CDA/Wiesenberger, a mutual fund tracking service.

"It's just very tough to beat the index that is, itself, leading the market advance," said Norman Fosback, the editor of the Mutual Fund Forecaster newsletter.

But local investment advisers said index funds aren't a cure-all for your investment needs. While the advisers say index funds are attractive investments, they should be only a portion of your overall holdings.

For starters, the most popular type of index fund is designed to match the performance of the S&P 500, which is made up of the nation's biggest publicly traded companies. While the S&P 500 index is diversified across many industries, about half of its market value is concentrated in 52 of the benchmark's largest companies.

That means if you invest $100 in an S&P 500 index fund today, about $3.09 will go to buy stock in General Electric, the company with the largest stock market value. Another $2.37 will go to buy Microsoft Corp. stock and $2.18 will go into Coca-Cola shares. Less than a penny will go into the stock of the Charming Shoppes, the retailer that owns Fashion Bug stores and the smallest member of the S&P 500.

As a result, local investment advisers said S&P 500
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index funds are a good substitute for actively managed investments in big company stocks. Index funds also have an added advantage because their expenses typically are about 1 percentage point lower than an actively managed fund.

"I cannot justify putting money with those active managers if a robot investment strategy will outperform them," said Anthony J. Ogorek, who runs Ogorek Asset Management in Williamsville.

Ogorek said he typically uses S&P 500 index funds as a core holding for his clients, equal to 25 percent to 40 percent of their investments.

But because the S&P 500 is made up only of big company stocks, an investor who focuses solely on that index will have no exposure to the shares of small- or medium-sized companies or stocks of firms based outside the United States.

"If you're just going to invest in those, you aren't going to be well diversified," said Richard K. Schroeder, a certified financial planner in Williamsville.

The S&P 500 index funds have been rewarded over the last four years because big company stocks have been the hottest part of the booming stock market. But sooner or later, those big company stocks are bound to cool off, and that likely will cause the S&P 500 index funds to lag behind other mutual funds that invest in small-company or international stocks.

That's exactly what happened from 1991 through 1993, when small-company shares were all the rage. Not coincidentally, that also was the last time more than half of the nation's actively managed funds managed to beat the S&P 500.

"Nothing lasts forever," Ogorek said. "At a given point in time, small-caps will outperform the large-cap domestics" and so will international stocks, which have lagged badly in recent years.

Of course, the boom in index funds has given investors many more choices.

T. Rowe Price Associates, for instance, jumped on the index bandwagon earlier this year by launching two more index funds that track the Wilshire 5000 and Wilshire 4500 indexes, which are designed to provide a snapshot of the broader stock market. The Vanguard Group, which offers a wide variety of index funds, earlier this year added two new index funds linked to small company and medium-sized company benchmarks. And investors now can buy shares in a unit investment trust, nicknamed Diamonds, that mimic the Dow Jones industrial average.

Yet investment advisers said index funds are a less appealing way to invest in smaller stocks or foreign shares. In those areas, a good fund manager has a better chance of bolstering returns by focusing on specific industries or making a few especially good stock selections.

"I'm not sure they're such a good substitute in the small-cap and overseas market" because it's harder to come up with a good index to use as a benchmark, said Alan Vogt, the president of Paramount Planning Inc., an Amherst investment advisory firm.

When the stock market is going strong, index funds have an added advantage because they are fully invested in stocks at all times. That boosts their returns over actively managed funds, which typically keep around 5 percent to 10 percent of their assets in cash as both a cushion against a downturn and to cover redemptions when shareholders decide to sell some of their holdings.

That can have a noticeable effect on an actively managed fund's returns. If the market goes up 30 percent in a given year, a fund that keeps 10 percent of its assets in cash will have its returns trimmed by 2.5 percentage points.

But that fully invested position could sting index funds when the market turns sour. If that happened, an index fund wouldn't have a cash reserve to handle redemptions, forcing it to sell shares to raise the money needed to pay the shareholders who are cashing out.

And, lacking the cash cushion, it's drop will be even more pronounced.

"If the area (market sector) goes bad, index funds are going to go bad, or worse," Vogt said.

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