Investor's Business Daily -Making Money in Mutual

The S&P 500 index is perhaps the most widely followed index in fund investing. While the Dow Jones industrial average gets the headlines, most stock portfolios are measured against the S&P 500. Mutual fund managers work to best it each year. Nine out of 10 don't.

What is the S&P 500 and what makes it so daunting? The definition, first delineated when the modern S&P was created in 1957, goes something like this: The S&P 500 is made up of 500 stocks that include 400 industrial, 40 utility, 20 transportation and 40 financial issues. The stocks are chosen by a committee that meets monthly to consider size, liquidity and industry representation. The index is market-cap weighted, meaning company size is part of the equation used to measure the index's performance. Market weighting is computed by multiplying the stock price times the number of shares outstanding. Market weighting gives Microsoft its clout as the biggest stock in the index. And it's why tiny Armco takes its place as the last name on the list. The base index number was 10, and in the quirky way of stock market analysis, represented what would have been the S&P 500 in 1941-43. By 1957, it was 45. The index is far larger today, closing at 984.59 Tuesday. The 500 stocks in the index represent about 75% of the stock market, down from 90% when the index was begun.

What gives the S&P clout is simple. Because of its breadth, it is seen by many as the best measure of stock market movement. It reflects what you get in return from doing little more than investing in the stock market. And because it often beats the average stock fund, the index bedevils fund managers (see The Long View above). This year, just 12% of actively managed general stock funds beat the index through Sept. 30, Lipper Analytical Services says. That works out to 440 of 3,670 funds. After all, if a professional can't beat a passive index, what's the point of paying fees for his or her services? That point has led to the growth of index funds, funds with portfolios that mirror an index. Assets in index funds now total more than $189 billion, according to Morningstar. That's up from $52 billion in '95. Vanguard Index Trust 500, at $55 billion in assets, is second in size only to actively managed, $66 billion Fidelity Magellan.

There are several reasons why the S&P 500 is so hard to beat. One is that mutual fund managers in aggregate represent the market, asserts Gus Sauter, managing director of Vanguard's index funds.

''All investors together own the market,'' he said. ''If you outperform the average, someone underperforms.''

Another reason is expenses, argues financial planner Scott Leonard in Santa Monica, Calif. Index funds don't require a lot of effort from a manager or a research department. The average actively managed stock fund has annual expenses of about 1.3% of assets, while an index fund can cost as little as 0.2%. Higher turnover for actively managed funds - 90% vs. 10% for index funds - triggers additional transaction costs, which act as a drag on performance.

''And that is the reason right there: Managers are too expensive,'' Leonard said. ''When you own 100 stocks your portfolio is going to track an index, but with managers who are a lot more expensive.''

One reason for the outperformance that's tied to the last bull market is big-cap stocks did best. And big stocks represent the bulk of the S&P 500. Most stocks funds have bigger weightings in companies far down the S&P cap-weighted list, or are off the list altogether. When the index surprised analysts by topping actively managed funds in the recent downturn, there was more head scratching.

Don't Time The Market

Managers of active funds may be seen as having an edge because they can sell stocks and raise cash to avoid a market downturn. But most stock managers use fundamental and momentum analysis to buy and sell stocks. They steer clear of predictions on where the market is headed. Most investors, managers included, eventually get burned trying to call the market. So many managers aim the bulk of their funds' assets toward their best ideas. They reason any decline will be temporary. The index changes a lot less than the average fund portfolio, but when it does, it can create a stir.

Companies vie for one of the dozen openings to become part of the index each year. Joining the S&P can bring an immediate 3% to 6% boost in a company's stock prices. That's because the listing guarantees greater demand for shares from the nearly 90 S&P index funds that will have to purchase stock as a result. Getting bumped from the list is a demerit. Just ask Chrysler. It was doomed once German automaker Daimler-Benz announced it was buying the company. Foreign companies haven't been allowed to join the S&P 500 since the '70s

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