IF anyone doubts that index funds have been among the hottest mutual-fund categories of 1995, he or she need only ring up the Vanguard Group.
Investor dollars have poured into the Vanguard Index Trust 500, which mimics the performance of the broad equity market by holding the stocks in the Standard & Poor's 500 index. Whatever the index does, the fund does essentially the same.
This year those investors have been well rewarded. As the S&P 500 shot up 29.27 percent through Oct. 31, the Vanguard tag-along surged 29.18. The slight difference is partly explained by a small management fee for the fund. The fund now has over $16 billion in assets.
But if the indexes are doing well, why shouldn't investors try to do even better by buying into funds that are actively managed - possibly by the next Peter Lynch, Fidelity's famed money manager?
The answer, say index-fund devotees, is that the unmanaged funds in recent years have typically beaten a majority of professional fund managers.
This year through Oct. 20, for example, the average return on 1,869 mutual funds investing in domestic stock tracked by Morningstar Inc. in Chicago was 26.46 percent, well below the 30.41 percent gain in the S&P 500. In years when small stocks are especially strong, such as 1991, '92, and '93, the S&P 500 (mostly large stocks) tends to lag behind the broader market, making it easier for managed funds to beat it.
Low operating expenses
Because index funds don't need to pay managers lots of money to pick stocks, operating expenses are low. According to Lipper Analytical Services, the average general equity fund has an annual expense ratio of 1.38 percent; the average taxable bond fund, 1.02 percent. Most index funds have an expense ratio falling well below 1 percent, often below 0.5 percent. A managed fund thus has to beat an index by a percentage point or so just to stay even. That isn't easy, with thousands of institutional money managers competing to respond to company earnings reports. Some will succeed in a given year; but many will not.
An added boon for index-fund investors is lower taxes. Since these funds will hold the same stocks for years, fund shareholders will receive smaller taxable capital-gains distributions.
With such advantages on investors' minds, index funds have multiplied. There are now 70 index funds reflecting both equity and bond indexes, according to the Investment Company Institute, a Washington-based trade group. Not surprisingly, most have done quite well in this year of gains in such popular indexes as the S&P 500, the Dow Jones industrial average, the Russell 2000 (small-company stocks), and the Wilshire 5000 index.
More than any company, Vanguard has written the book on index funds. The Valley Forge, Pa., firm now has 14 different index funds - including ones for overseas and small-company stocks - with nearly $30 billion in total assets. Its Index Trust 500, established in 1976, was the first index fund in the United States.
Short-term investors beware
As happy as Vanguard is about this year's growth, there is still some concern about both the torrid pace of new money coming into the Index Trust 500 fund, and the spectacular climb of the equities market. In June, Vanguard chairman John Bogle wrote an unprecedented cautionary letter to prospective investors, reminding them that index funds are not for ''short-term'' investors eager to temporarily ride a soaring market.
The reason: While index funds rise as the market climbs, they also fall as the market sags. In recent days, the stock market has gained substantially. But if there is a market correction, the index funds will head south proportionally.
Unlike many index funds that hold only a representative sample of the stocks in their targeted index, the Vanguard Index Trust 500 buys all of the 500 companies in the S&P 500, in proportion to each firm's market capitalization. The firm also has a series of four Vanguard Lifestrategy Funds, each a partially indexed blend of stocks and bonds. The equity portion of the funds is invested in an index portfolio.
Some financial specialists say people should have no more than 5 to 10 percent of their assets in any special-strategy fund, including index funds.
Moreover, some experts say investors can aim higher than just duplicating market averages. ''Our experience is that our member clubs usually exceed market averages in any year,'' says Thomas O'Hara, chairman of the National Association of Investors Corp., an association of investor clubs and individual investors in Madison Heights, Mich. ''Exceeding averages can be possible for most investors.''