MERRILL LYNCH
INDEX
FUNDS, INC.
STRATEGIC
Performance
Quarterly Report
September 30, 1997
<PAGE>
MERRILL LYNCH INDEX FUNDS, INC.
Officers and Terry K. Glenn, President and Director
Directors Jack B. Sunderland, Director
Stephen B. Swensrud, Director
J. Thomas Touchton, Director
Norman R. Harvey, Senior Vice President
Joseph T. Monagle Jr., Senior Vice President
Gregory Mark Maunz, Vice President and Portfolio Manager
Eric S. Mitofsky, Vice President and Portfolio Manager
Jay C. Harbeck, Vice President and Portfolio Manager
Gerald M. Richard, Treasurer
Ira P. Shapiro, Secretary
Custodian
State Street Bank and Trust Company
P.O. Box 351
Boston, MA 02101
Transfer Agent
Merrill Lynch Financial Data Services, Inc.
4800 Deer Lake Drive East
Jacksonville, FL 32246-6484
(800) 637-3863
<PAGE>
Merrill Lynch Index Funds, Inc., September 30, 1997
DEAR SHAREHOLDER
We are pleased to provide you with this first quarterly report for Merrill Lynch
Index Funds, Inc. In this report, we will discuss the investment environment and
performances of Merrill Lynch Aggregate Bond Index Fund, Merrill Lynch
International Index Fund, Merrill Lynch S&P 500 Index Fund and Merrill Lynch
Small Cap Index Fund. Complete performance information, including aggregate
total returns, can be found on pages 6 and 7 of this report to shareholders.
Merrill Lynch Aggregate Bond Index Fund
Merrill Lynch Aggregate Bond Index Fund is comprised of investment grade
fixed-income securities from the Government, agency, mortgage-backed, corporate
and asset-backed sectors. The primary objective of the Fund is to seek to
provide investment results that, before expenses, replicate the total return of
the Lehman Brothers Aggregate Bond Index. The Fund seeks to achieve its
objective by investing all of its assets in Merrill Lynch Aggregate Bond Index
Series. To be eligible for inclusion in the Index, a security must meet certain
size, maturity and credit rating requirements. The Index had 6,239 issues at
September 30, 1997.
Because of liquidity concerns and availability, the Series does not own all of
the securities in the benchmark Index. Rather, we attempt to achieve our
investment objective through the implementation of aggregation strategies. In
other words, by grouping the portfolio into many sectors whose investment
characteristics are substantially similar to the corresponding sectors of the
Index, substantially similar measures of total return should result.
The largest sector of the Index is comprised of Government and Government agency
securities, which represents 50% of the Index. This sector has 1,490 issues and
an effective duration (sensitivity of price to changes in interest rates) of
4.97 years. The Series' Government sector has 18 issues but matches the
Government sector of the Index regarding key measures, including effective
duration. The mortgage-backed sector represents 30% of the Index and has 624
issues, all of which are issued by the Government National Mortgage Association,
the Federal National Mortgage Association or the Federal Home Loan Mortgage
Corporation. The Series' mortgage-backed sector currently has 24 issues and
seeks to mimic the mortgage index on a coupon, original term (30-year, 15-year
and balloon) and issuer basis. While the corporate sector has the greatest
number of issues at 4,075, this sector only accounts for 20% of the Index.
Similar to the Government sector, the corporate sector is managed on a neutral
basis to effective duration, and other key measurements. In addition, industry
matching is performed in the corporate sector. The Series' portfolio currently
has 71 issues in this sector. Deviation of total return of the Fund to the
benchmark is referred to as tracking error and can be either positive or
negative. Tracking error can result from factors outside the control of
management. Examples include timing lag between share purchases and the
reporting of share purchases, differences in mortgage prepayments of actual
pools and the generic prepayments reported by the agencies, and transaction
expenses. Tracking error for the September quarter was minimal in spite of the
fact that expectation of higher tracking error would take place in a market
environment which featured high interest rate fluctuation and volatility. The
volatility of the quarter is exhibited by the movement of the ten-year Treasury
note, which started the period with a yield of 6.50%. By the end of July, the
yield on the note had declined to 6.01%. August saw the yield rebound to 6.40%
in mid-month before closing the month at 6.34%. September brought about another
whipsaw as the note closed the month at 6.10%, after trading as low as 6.03%.
Merrill Lynch International Index Fund
The quarter ended September 30, 1997 was a volatile period for international
equity markets. During the third quarter of 1997, stock market returns for the
Pacific Basin were negative, as measured by the unmanaged Morgan Stanley Capital
International (MSCI) Indexes, while European equities finished with gains.
The total return for the MSCI EAFE(R) Index-GDP Weighted was +0.97% for the
September quarter.
The Asian markets suffered losses because of several factors. The key factor
was, and still is, the Southeast Asian currency crisis. Of all the countries in
the MSCI EAFE Index, Malaysia was most affected by currency devaluation in the
region, down nearly 42% for the September quarter. The general economic health
of the region is still in question. Another contributing factor was the
volatility in the United States. The August downturn on US markets brought the
world markets down with it. All of the countries represented in the MSCI EAFE
Index were either negative or flat in August, as the MSCI EAFE Index-GDP
Weighted lost 7.28%, while the S&P 500 fell 5.74% in the United States. Concerns
about currency valuations and its residual effects reverberated throughout the
region sending Japan (-12.9%), Singapore (-7.9%) and Hong Kong (-2.6%) down for
the quarter ended September 30, 1997.
On the positive side, Europe was up enough to make up for the problems in the
Pacific Basin and push the Index into positive territory for the September
quarter. Italy was the largest contributor to positive performance, up 17.5% for
the quarter. Germany, the highest weighted of the European countries in the
Index, was up 6.2%. In addition, the United Kingdom was up 11.1%, adding to
Europe's gains.
The Fund invests all of its assets in Merrill Lynch International Index Series,
which has the same investment objective as the Fund. The value of the Fund's
investment in the Series reflects the Fund's proportionate interest in the net
assets of the Series. There are two principal investments made by the Series in
its attempt to replicate the returns of the Index (before expenses). First, the
Series holds a basket of stocks designed to replicate the Index, with share
quantities designed to closely approximate each country's actual weight in the
Index. In addition, the Series holds positions in several futures contracts
which are used primarily as a means of quickly converting daily cash inflows
into equity exposure. These futures contracts also provide an efficient
mechanism for keeping a pool of liquidity available to meet potential Fund
redemption activity. As of the end of September, the Series' equity portfolio
was valued at $137.7 million, and the Series held positions in futures contracts
valued at $9.3 million. Our investment strategy is to be 100% invested at all
times.
The Fund's net assets grew steadily during the third quarter, and by September
30, 1997 stood at $146,984,595. This compares to net assets of $127,364,046 on
June 30, 1997. There were no major constituent changes to the Index during this
period. Trades were made during the September quarter to sell futures and buy
equities. These trades serve the purpose of lowering the potential tracking
difference between the Index and the Fund.
Merrill Lynch S&P 500 Fund
The unmanaged Standard & Poor's (S&P) 500 Composite Index posted a strong +7.53%
total return during the quarter ended September 30, 1997, as investor concerns
over building inflationary pressure in the economy appeared to subside during
July and September. However, such worries led to significant declines in both
the bond and equity markets during August. Having ended the second quarter of
1997 at 885.14 on June 30, 1997, the S&P 500 Composite Index pushed ahead and
established a new all-time high of 960.32 on August 6, 1997. This marked the end
of the nearly four-month advance that began in mid-April, during which the S&P
500 Index rose 222.67 points. In August, concerns over rising interest rates and
stronger-than-expected economic growth led to a broad-based decline in
large-capitalization stocks. This culminated in a 23.96 point drop in the S&P
500 Index on August 15, 1997, taking the Index down to 900.81. Financial stocks
were especially hard-hit during the month, with the S&P Financial Index
declining by 7.6% in August. The Index finished the month at 899.47, making
August only the second month during 1997 in which the S&P 500 declined.
September began with an abrupt reversal as the Index gained 28.11 points on the
first trading day of the month. Continued favorable economic reports led to
strongly
2 & 3
<PAGE>
rebounding stock and bond markets in September. The S&P 500 Index produced a
+5.47% total return for the month.
Cash flow into Merrill Lynch S&P 500 Fund continued at a strong pace throughout
the quarter and, combined with the continuing advance in the market, the Fund's
net assets exceeded $500 million for the first time on September 26, 1997. As of
September 30, 1997, the Fund's net asset level was approximately $505 million,
which represents a 71.75% increase over the June 30, 1997 level of approximately
$294 million.
The Fund invests all of its assets in Merrill Lynch S&P 500 Index Series, which
has the same investment objective as the Fund. The value of the Fund's
investment in the Series reflects the Fund's proportionate interest in the net
assets of the Series. The principal investments of the Series are a fully
replicating portfolio of all 500 stocks in the Index and a position in S&P 500
futures contracts, which are used to quickly convert daily cash flows into the
Fund into equity exposure. At the end of September, the Series' equity portfolio
was valued at $466,887,253. In addition, the Series held a position in S&P 500
December 1997 futures contracts. Our goal is to be 100% invested at all times.
The quarter ended September 30, 1997 was an active one regarding composition
change activity within the Index, resulting in the addition of several new
equity positions to the Series. These included Washington Mutual, Inc.,
SunAmerica Inc., Apache Corp., Anadarko Petroleum Corp., NextLevel Systems Inc.,
Owens- Illinois, Inc., Progressive Corp., Huntington Bancshares Inc., Mirage
Resorts, Inc., Fort James Corp., State Street Corp., KLA-Tencor Corp., and Clear
Channel Communications, Inc.
Merrill Lynch Small Cap Index Fund
The significant underperformance of the small-capitalization sector during the
first half of 1997 was all but erased as the unmanaged Russell 2000 Index posted
a solid +14.88% total return during the quarter ended September 30, 1997. Most
notable was the performance of the Russell 2000 Index in August, when it
produced a total return of +2.29%, compared to a total return for the unmanaged
S&P 500 Index of -5.61%. The gains continued in September, as the Russell Index
advanced on all but four of the 21 trading sessions during that month, closing
the quarter at an all-time high index level of 453.82, a gain of 57.45 index
points. On a year-to-date basis, the total return of the Russell 2000 Index
through September 30, 1997 was +26.60%.
Cash flow into Merrill Lynch Small Cap Index Fund escalated dramatically
compared with the levels during the second quarter of 1997 after the Fund's
inception. The strong inflow of new cash, coupled with the rapid advance in the
market, led the Fund's net assets to more than double during the third quarter
alone, and end September at $85,401,397. Compared with the Fund's net assets of
$40,285,893 on June 30, 1997, this represents an increase of 111.99%.
The Fund invests all of its assets in Merrill Lynch S&P 500 Index Series, which
has the same investment objective as the Fund. The value of the Fund's
investment in the Series reflects the Fund's proportionate interest in the net
assets of the Series.
Because of the illiquid nature and wide bid-offer spreads of many of the
components of the Russell 2000, investing cash flows of this magnitude can be
difficult and adds to expenses. It is not the objective of the Series to own all
of the equities comprising the underlying Index. Rather, the Series prefers to
purchase an optimized basket of stocks designed to produce returns which closely
approximate those of the Index. Incremental cash is used to purchase positions
in stocks with the intention of reducing the predicted tracking error of the
portfolio. We therefore expect that the Series' tracking error will be reduced
as cash continues to come into the Series. As of September 30, 1997, the Series'
equity portfolio consisted of approximately 1,300 stocks and was valued at $73.7
million. In addition, the Series held a position in Russell 2000 futures
contracts. Wherever possible the Series attempts to utilize "crossing networks,"
where stocks may be purchased (or sold) with less overall market impact, and
with less cost.
In Conclusion
We appreciate your investment in Merrill Lynch Index Funds, and we look forward
to updating you in our upcoming annual report to shareholders.
Sincerely,
/s/ Terry K. Glenn
Terry K. Glenn
President
/s/ Jay C. Harbeck
Jay C. Harbeck
Vice President and
Co-Portfolio Manager
Merrill Lynch Aggregate Bond
Index Fund
/s/ Gregory Mark Maunz
Gregory Mark Maunz
Vice President and
Co-Portfolio Manager
Merrill Lynch Aggregate Bond
Index Fund
/s/ Eric S. Mitofsky
Eric S. Mitofsky
Vice President and Portfolio Manager
Merrill Lynch International Index Fund
Merrill Lynch S&P 500 Fund
Merrill Lynch Small Cap Index Fund
November 12, 1997
4 & 5
<PAGE>
Merrill Lynch Index Funds, Inc., September 30, 1997
PERFORMANCE DATA
About Fund Investors are able to purchase shares of the Fund through
Performance the Merrill Lynch Select Pricing(SM) System, which offers
two pricing alternatives:
o Class A Shares do not incur a maximum initial sales charge
(front-end load) or deferred sales charge and bear no
ongoing distribution or account maintenance fees. Class A
Shares are available only to eligible investors.
o Class D Shares do not incur a maximum initial sales charge
or deferred sales charge and bear no ongoing distribution
fee. In addition, Class D Shares are subject to an ongoing
account maintenance fee of 0.25%.
None of the past results shown should be considered a
representation of future performance. Figures shown in the
"Aggregate Total Return" tables assume reinvestment of all
dividends and capital gains distributions at net asset
value on the payable or ex-dividend date. Investment return
and principal value of shares will fluctuate so that
shares, when redeemed, may be worth more or less than their
original cost. Dividends paid to each class of shares will
vary because of the different levels of account
maintenance, distribution and transfer agency fees
applicable to each class, which are deducted from the
income available to be paid to shareholders.
Aggregate Bond
Index Fund
Recent
Performance
Results
<TABLE>
<CAPTION>
Since Inception+ 3 Month
9/30/97 6/30/97 4/03/97+ % Change % Change
====================================================================================================================
<S> <C> <C> <C> <C> <C>
ML Aggregate Bond Index Fund Class A Shares $10.32 $10.14 $10.00 +3.20% +1.78%
- --------------------------------------------------------------------------------------------------------------------
ML Aggregate Bond Index Fund Class D Shares 10.32 10.15 10.00 +3.20 +1.67
- --------------------------------------------------------------------------------------------------------------------
ML Aggregate Bond Index Fund Class A Shares-Total Return +6.42(1) +3.37(2)
- --------------------------------------------------------------------------------------------------------------------
ML Aggregate Bond Index Fund Class D Shares-Total Return +6.29(3) +3.20(4)
====================================================================================================================
</TABLE>
+ The Fund commenced operations on April 3, 1997.
(1) Percent change includes reinvestment of $0.293 per share ordinary income
dividends.
(2) Percent change includes reinvestment of $0.159 per share ordinary income
dividends.
(3) Percent change includes reinvestment of $0.282 per share ordinary income
dividends.
(4) Percent change includes reinvestment of $0.153 per share ordinary income
dividends.
International
Index Fund
Recent
Performance
Results
<TABLE>
<CAPTION>
Since Inception+ 3 Month
9/30/97 6/30/97 4/03/97+ % Change % Change
====================================================================================================================
<S> <C> <C> <C> <C> <C>
ML International Index Fund Class A Shares $11.65 $11.52 $10.00 +16.50% +1.13%
- --------------------------------------------------------------------------------------------------------------------
ML International Index Fund Class D Shares 11.64 11.52 10.00 +16.40 +1.04
- --------------------------------------------------------------------------------------------------------------------
ML International Index Fund Class A Shares-Total Return +16.50 +1.13
- --------------------------------------------------------------------------------------------------------------------
ML International Index Fund Class D Shares-Total Return +16.40 +1.04
====================================================================================================================
</TABLE>
+ The Fund commenced operations on April 9, 1997.
S&P 500
Index Fund
Recent
Performance
Results
<TABLE>
<CAPTION>
Since Inception+ 3 Month
9/30/97 6/30/97 4/03/97+ % Change % Change
====================================================================================================================
<S> <C> <C> <C> <C> <C>
ML S&P 500 Index Fund Class A Shares $12.72 $11.84 $10.00 +27.20% +7.43%
- --------------------------------------------------------------------------------------------------------------------
ML S&P 500 Index Fund Class D Shares 12.70 11.84 10.00 +27.00 +7.26
- --------------------------------------------------------------------------------------------------------------------
ML S&P 500 Index Fund Class A Shares-Total Return +27.20 +7.43
- --------------------------------------------------------------------------------------------------------------------
ML S&P 500 Index Fund Class D Shares-Total Return +27.00 +7.26
====================================================================================================================
</TABLE>
+ The Fund commenced operations on April 3, 1997.
Small Cap
Index Fund
Recent
Performance
Results
<TABLE>
<CAPTION>
Since Inception+ 3 Month
9/30/97 6/30/97 4/03/97+ % Change % Change
====================================================================================================================
<S> <C> <C> <C> <C> <C>
ML Small Cap Index Fund Class A Shares $13.17 $11.51 $10.00 +31.70% +14.42%
- --------------------------------------------------------------------------------------------------------------------
ML Small Cap Index Fund Class D Shares 13.16 11.51 10.00 +31.60 +14.34
- --------------------------------------------------------------------------------------------------------------------
ML Small Cap Index Fund Class A Shares-Total Return +31.70 +14.42
- --------------------------------------------------------------------------------------------------------------------
ML Small Cap Index Fund Class D Shares-Total Return +31.60 +14.34
====================================================================================================================
</TABLE>
+ The Fund commenced operations on April 9, 1997.
Aggregate Bond
Index Fund
Aggregate
Total Return
% Return
================================================================================
Class A Shares
================================================================================
Inception (4/03/97) through 9/30/97 +6.42%
- --------------------------------------------------------------------------------
% Return
================================================================================
Class D Shares
================================================================================
Inception (4/03/97) through 9/30/97 +6.29%
- --------------------------------------------------------------------------------
International
Index Fund
Aggregate
Total Return
% Return
================================================================================
Class A Shares
================================================================================
Inception (4/09/97) through 9/30/97 +16.50%
- --------------------------------------------------------------------------------
% Return
================================================================================
Class D Shares
================================================================================
Inception (4/09/97) through 9/30/97 +16.40%
- --------------------------------------------------------------------------------
S&P 500
Index Fund
Aggregate
Total Return
% Return
================================================================================
Class A Shares
================================================================================
Inception (4/03/97) through 9/30/97 +27.20%
- --------------------------------------------------------------------------------
% Return
================================================================================
Class D Shares
================================================================================
Inception (4/03/97) through 9/30/97 +27.00%
- --------------------------------------------------------------------------------
Small Cap
Index Fund
Aggregate
Total Return
% Return
================================================================================
Class A Shares
================================================================================
Inception (4/09/97) through 9/30/97 +31.70%
- --------------------------------------------------------------------------------
% Return
================================================================================
Class D Shares
================================================================================
Inception (4/09/97) through 9/30/97 +31.60%
- --------------------------------------------------------------------------------
6 & 7
<PAGE>
This report is not authorized for use as an offer of sale
or a solicitation of an offer to buy shares of the Funds unless accompanied or
preceded by the Funds' current prospectus. Past performance results shown in
this report should not be considered a representation of future performance.
Investment return and principal value of shares will fluctuate so that shares,
when redeemed, may be worth more or less than their original cost. Statements
and other information herein are as dated and are subject to change.
Merrill Lynch
Index Funds, Inc.
Box 9011
Princeton, NJ
08543-9011 Index Q-9/97
[LOGO] Printed on post-consumer recycled paper
