Could Be a Future or Two in Your Index Fund

A strange thing happened last quarter with some mutual funds that track the Standard & Poor’s 500: Seven of these index funds matched or beat the S&P; 500’s performance.

That’s not supposed to happen.

Index funds should lag a step or two behind the yardsticks they track, for the simple reason that the performance of an index isn’t reduced by shareholder-borne expenses, whereas all mutual fund results are.

S&P; 500 index funds incur expenses of 47 so-called basis points, on average, equal to 47 hundredths of a percentage point, says fund researcher Lipper Analytical Services in Summit, N.J. Thus, it stands to reason that the funds themselves should trail the market yardstick by roughly that amount.

Usually they do. But the reason a few overachievers will occasionally beat the index can be explained by the wise and fortuitous use of futures contracts by portfolio managers.

Futures pegged to the S&P; 500 are instruments whose values rise or fall in lock-step, more or less, with the prices of the 500 underlying stocks. But as with other assets, the price of a futures contract sometimes drops below the stocks’ underlying value, based on swings in supply and demand. This creates opportunities for shrewd index fund managers to spot a bargain here or there.

“If futures are cheap compared with the underlying stocks, we’ll buy the futures,” says Gus Sauter, who heads the index fund operations at the Vanguard Group in Valley Forge, Pa. “In fact, the key decision we have to make each day is whether to buy futures or stocks, because futures prices can move quickly.”

The common use of futures contracts by S&P; 500 index funds means that these portfolios aren’t as plain-vanilla as shareholders might think. Futures contracts are complex and volatile instruments that, if misused, can backfire.

“Matching the index’s performance is OK, but beating it bothers me,” says A. Michael Lipper, president of Lipper Analytical, citing the speculative nature of futures. “I’d be concerned about [index-beating funds from] smaller groups that lack a strong independent board of directors and highly professional compliance people.”

But it’s tough for shareholders to assess the caliber of a fund’s directors or its policing staff. A more realistic response would be to make sure a fund’s performance isn’t drifting far out of line compared with the index itself. If it is, that could be a signal the fund manager is speculating.

For the most part, returns on S&P; 500 funds tend to fall within a narrow range, as investors would expect. For the 12 months ended June 30, for example, the performance gap between the top-ranked Vanguard Institutional Index Fund and the last-place Compass Equity Index B portfolio was 2 percentage points.

S&P; 500 index fund managers who use futures contracts argue that they are doing so for conservative, hedging purposes, not for speculation.

“We don’t use futures to increase the risk of the fund,” says Laurie White, senior portfolio manager of Norwest Advantage Index, a Minneapolis fund that beat the S&P; 500 for the first and second quarters of 1997. “They are meant purely to hedge a cash position.”

In other words, the Norwest fund, like many others, keeps some cash in short-term investments to meet shareholder redemptions. Because cash investments won’t match the stocks in the index, futures contracts are purchased to offset what could be a drag on a fund’s performance.

Sauter says Vanguard’s index fund managers buy futures contracts only when the contracts are cheap compared with the underlying stocks, as determined by computerized models.

“We only go after futures when the odds are greatly in our favor,” he says.