They claim even monkeys can do it. Just blindfold the animal - I know activists Jane Goodall and the likes will be up in arms over this and I'm not suggesting you do it - and let it throw darts at a dart board with a list of stocks pinned onto it. They say there's a high likelihood that over time, the group of stocks picked by the monkey will do as well - if not better - as the portfolio that's meticulously tailored by your fund manager! That, in a nutshell, is what evangelists of index funds are preaching. If that's the case, why not just have a basket of stocks that mimics the index and let it go autopilot?

FUND MANAGERS ARE UP IN ARMS

The controversial thought - understandably many fund managers are incensed by the idea - and others of similar nature led to the Efficient Market Theory in the early 1970s. It was made famous in the book called "A Random Walk Down Wall Street." How does it work? Well, it believes that investors own all the stocks in the market and the price at which they are willing to pay is based on market information. If that's the case, the only thing driving up stock prices is exclusive market information. However no fund manager can act on a piece of exclusive information for long because the whole market will soon come to know about it and will react accordingly. That means EVERYBODY moves in tandem very quickly so that it becomes difficult for you to buy low and sell high. The theory therefore concludes that no manager can consistently outdo the market average or index. The whole argument, however, HINGES heavily on the assumption that information is easily available. It's also based on the US experience, where everyday there are some 10,000 financial analysts going over all the stocks with a fine-tooth comb.

STATISTICAL EVIDENCE

Statistical evidence seems to back the theory. A study by the Wall Street Journal found that the S&P 500 Index outperformed 87% of mutual fund managers from 1969 to 1979. A separate study by Lipper Analytical Services concluded that the S&P 500 did better than 88% of the mutual funds from 1984 to 1988. Also noteworthy is that no fund manager in the US has been able to beat the S&P 500 every year over a consecutive 5-year period.

BIRTH OF THE INDEX FUND

The Efficient Market Theory led to the birth of Index Funds. There are obvious plus points. Its biggest attraction is the very low or zero upfront fees (also known as no loads). And the annual management fee is modest because the fund manager doesn't really need to tinker with the fund as it copies the index. Because of that, there isn't a need to hire a research team to determine which stocks to buy and sell. Also missing are costs like brokerage fees which are incurred when the manager buys and sells stocks in the portfolio.

INDEXING OUTSIDE THE US?

Is indexing a good strategy for investing in countries outside the US? Having funds that track the indexes of inefficient markets may not be such a great idea. In inefficient markets where information is not easily available, there is a time lag before a stock price reacts to a new piece of information. In these places, fund managers are able to make a profit from the price difference - hence the value of professional stock picking. Even in the US, which is supposedly an efficient market, there are pockets of inefficiency! People may buy or sell shares purely out of emotional impulse and not just based on information. Investors may also overreact to news and cause stock prices to be grossly overvalued or undervalued over a period of time - look at the bull run in the US and the recent bearish turn of events.

Of late, there has been a compromise in the debate over the value of index funds. There seems to be some consensus that perhaps index funds should make up part of your portfolio - like the plain vanilla portion comprising good old bonds and such likes.

If you have any comments, send them to soohow@fundsupermart.com.