MERRILL LYNCH
INDEX
FUNDS, INC.
[GRAPHIC OMITTED]
STRATEGIC
Performance
Quarterly Report
September 30, 1998
<PAGE>
MERRILL LYNCH INDEX FUNDS, INC.
Officers and Directors
Terry K. Glenn, President and Director
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
Jay C. Harbeck, Senior Vice President and
Portfolio Manager
Jeffrey B. Hewson, Senior Vice President and
Portfolio Manager
Gregory Mark Maunz, Senior Vice President and
Portfolio Manager
Eric S. Mitofsky, Senior Vice President and
Portfolio Manager
Donald C. Burke, Vice President
Gerald M. Richard, Treasurer
Ira P. Shapiro, Secretary
Custodian
For Merrill Lynch Aggregate Bond Index Fund,
Merrill Lynch S&P 500 Index Fund and
Merrill Lynch Small Cap Index Fund:
Merrill Lynch Trust Company
800 Scudders Mill Road
Plainsboro, NJ 08536
For Merrill Lynch International Index Fund:
State Street Bank and Trust Company
P.O. Box 351
Boston, MA 02101
Transfer Agent
Financial Data Services, Inc.
4800 Deer Lake Drive East
Jacksonville, FL 32246-6484
(800) 637-3863
<PAGE>
Merrill Lynch Index Funds, Inc., September 30, 1998
DEAR SHAREHOLDER
We are pleased to provide you with this quarterly report for Merrill Lynch Index
Funds, Inc. In this report, we will discuss the investment environments for 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. (Fund results shown do not reflect sales charges; results
shown would be lower if sales charges were included. Complete performance
information, including average annual total returns, can be found on pages 6 and
7 of this report to shareholders.)
Merrill Lynch Aggregate Bond Index Fund
The primary investment objective of Merrill Lynch Aggregate Bond Index Fund is
to seek to provide investment returns that, before expenses, replicate the total
return of the unmanaged Lehman Brothers Aggregate Bond Index. This Index is a
highly recognized and widely referenced benchmark and often used when measuring
performance in the investment-grade fixed-income market. For the quarter ended
September 30, 1998, the Fund's Class A and Class D Shares had total returns of
+4.21% and +4.15%, respectively, compared to a total return of +4.23% for the
Index.
At September quarter-end, there were 6,932 securities in the Index, an increase
of 231 issues from the June quarter. The Index consists of securities from three
major high-quality investment sectors. The largest sector is comprised of US
Government and agency bonds and accounts for 47.6% of the Index. As of September
30, 1998, this sector had 1,840 securities. The US Government mortgage-backed
securities (MBS) sector is the next largest at 30.7% of the Index with 599
positions. The final sector is represented by investment-grade corporate
securities, which accounted for 21.7% of the Index at the end of the quarter.
The Fund seeks to achieve its objective by investing all of its assets in
Merrill Lynch Aggregate Bond Index Series. Each of the three sectors within the
Series is separately managed and as of September 30, 1998 was comprised of 194
positions. The US Government and agency and corporate sectors are managed
similarly. In these two sectors, the Series seeks to neutralize duration.
Duration is an indicator of expected price volatility of a security (or group of
securities) when interest rates change. Hence, if the duration of each sector is
identical to the corresponding sector in the Index, then the price movement of
that sector in the Series should match the price movement in the Index of that
particular sector. In addition, duration matching techniques are not complete
until we conduct an analysis of the duration exposure for each part of the yield
curve and match the distribution of the duration to ensure identical exposure.
Therefore, the Series applies neutral partial duration in addition to total
duration management to ensure tracking errors do not surface as a result of
changes in the shape of the yield curve.
In addition to duration matching, we employ other strategies to match the Series
to its index counterpart. It is critical that industry subsector exposure along
with credit rating neutrality are achieved in order for tracking deviation to
remain at a minimum level.
Unlike the US Government and agency and corporate sectors, which have
well-defined maturities and therefore absolute durations, the MBS sector of the
Series is subject to prepayments, which impact duration. Since analysis can be
done to estimate future prepayments, the duration can be calculated assuming
these projected prepayments. However, since an uncertainty of prepayments
exists, there also is an uncertainty of duration. Accordingly, rather than
managing the MBS sector using duration neutrality, we manage this sector of the
Series by matching product. This entails having neutral exposure to coupon
(5.5%-11%), mortgage original term (30-year, 15-year and balloon) and agency
issues.
Merrill Lynch International Index Fund
For the three months ended September 30, 1998, Merrill Lynch International Index
Fund's Class A and Class D Shares had total returns of -14.69% and -14.76%,
respectively. This compares to the Fund's benchmark, the unmanaged Morgan
Stanley Capital International EAFE (Europe, Australasia, Far East) Gross
Domestic Product (GDP) Weighted Index (MSCI EAFE Index), which produced a total
return of -14.50% in US dollar terms for the quarter ended September 30, 1998.
Double-digit declines occurred in nearly all major stock markets throughout the
world during the third quarter of 1998, as fallout from Asia's economic and
currency crises led to higher levels of volatility in all market segments.
Global uncertainty and perceptions of greater risk around the world have caused
equity markets to suffer their most serious setback since the Persian Gulf War.
Some nations, such as the United Kingdom, have already fallen by as much from
their highs as they did during the bear market of 1987. All major markets
included in the MSCI EAFE Index suffered accordingly in the third quarter. As
measured by the MSCI constituents in each country in US dollar terms for the
quarter ended September 30, 1998, Japan was down by 14.96%; Germany declined by
15.55%; the United Kingdom fell by 10.95%; France was down by 16.42%; and Italy
declined by 9.90%. The worst-performing countries in the EAFE Index during the
third quarter of 1998 were Malaysia (-38.58%), which was removed from the Index
on September 30, and Norway, which declined by 29.57%. Of all the EAFE
countries, only Hong Kong managed to produce a positive result for the quarter,
gaining 0.60%.
In contrast to the second quarter of 1998, European markets were unable to
cushion the effect of the declining Asian components of the Index. On a regional
basis, MSCI Europe was down by 14.42% and the MSCI Pacific Index lost 13.65%
during that same period. In contrast to the recovery posted by the US equity
market during September, the malaise affecting most of the EAFE countries could
not be reversed during that month. Only Australia, Malaysia and Singapore
managed to recover any ground off of their August lows during September.
Cushioning the blow for US investors was the recent instability of the dollar,
which has corrected sharply relative to many of the major EAFE currencies since
the end of June.
Merrill Lynch International Index Fund invests all of its assets in Merrill
Lynch International Index Series, which has the same investment objective as the
Fund. There are two principal investments made by the Series in its attempt to
replicate the returns of the Index. First, the Series holds a basket of stocks
designed to replicate the returns of the Index, with share quantities designed
to closely approximate each country's actual weight in the Index. In addition,
the Series maintains positions in several foreign futures contracts, which are
available in most of the major foreign markets in the EAFE Index. These futures
contracts provide an efficient mechanism for maintaining equity exposure while
also keeping a pool of liquidity available to meet potential Fund redemption
activity. As of September 30, 1998, the Series' equity portfolio was valued at
$98.45 million, and the Series' various foreign futures contracts were valued at
$6.4 million. It is the Series' goal to be as close as possible to 100% invested
at all times. On June 30, 1998, the Fund's net assets stood at $111.5 million.
This compares to $89.5 million on September 30, 1998, and represents a decrease
of 19.7% during the September quarter.
Merrill Lynch S&P 500 Index Fund
After reaching another all-time high of 1186.75 on July 17, 1998, renewed
concerns regarding Asia combined with weakening earnings prospects for domestic
companies and sent the Standard & Poor's 500 Composite Index (S&P 500) on a
rapid descent through the end of the month. At July 31, 1998, the Index had
dropped more than 66 points, finishing July at a level of 1120.67. Fear of the
spreading economic crisis in many emerging markets of the world fully gripped
financial markets in the United States, as extreme levels of volatility
continued throughout August. During August, the S&P 500 Index suffered its worst
one-month decline since the crash of October 1987, and its ninth-largest
one-month decline since 1929. The S&P 500 Index declined by 14.58% in August
culminated by a 70-point drop on August 31, 1998. This brought the Index back to
957.28, nearly 230 points off its peak of July 17, marking its first close below
1000 since January 30, 1998.
The month of September began with a fierce rally as the Index gained
2 & 3
<PAGE>
Merrill Lynch Index Funds, Inc., September 30, 1998
nearly 37 points on the first day of the month, retracing a good part of its
losses on the prior day. Extreme levels of volatility continued throughout
September, with gains or losses of 20 Index points-30 Index points becoming
commonplace. Overall, the Index produced a strong gain of 6.24% during
September, but the month was capped off by a 32-point drop on the last day of
trading. This was the market's response to the Federal Reserve Board's 25 basis
point reduction (0.25%) in the Federal Funds rate on the prior day, which was
viewed as inadequate. The Index finished the third quarter of 1998 at 1017.01,
with a total return for the three-month period ended September 30, 1998 of
- -9.95%.
Financial stocks were especially hard-hit during the September quarter, along
with the capital goods and consumer cyclical groups. The traditional safe haven
of utilities strongly outperformed the broad market during this volatile
quarter, and was the S&P 500's best-performing sector during this period.
Technology and energy stocks also strongly outperformed the overall market for
this three-month period. Despite the increasing turmoil of financial markets
throughout the world, it was once again the largest-capitalization multinational
stocks in the United States that fared better than other capitalization groups.
This factor helped lay to rest yet another myth regarding index funds--that they
would underperform active funds in a down market. On the contrary, S&P 500 Index
funds continued to outperform the majority of diversified equity funds during
the September quarter, according to Lipper Analytical Services.
For the quarter ended September 30, 1998, Merrill Lynch S&P 500 Index Fund's
Class A and Class D Shares had total returns of -10.04% and -10.12%,
respectively. Since inception (April 3, 1997) through September 30, 1998, the
Fund's Class A and Class D Shares have had total returns of +38.20% and +37.71%,
respectively. This compares to the Fund's benchmark, the S&P 500 Index, which
had total returns of -9.95% for the quarter ended September 30, 1998 and +38.90%
for the same period since inception to September 30, 1998.
Recent data indicated that significant net withdrawals from US equity mutual
funds occurred during August, which became the first month since September 1990
that equity mutual funds experienced net withdrawals. Simultaneously, investors
poured money into fixed-income products, primarily seeking the safety of US
Treasury bonds, which drove down the yield to the 5% level. However, cash flow
into Merrill Lynch S&P 500 Index Fund continued at a solid pace throughout the
entire September quarter. The Fund closed the quarter with net assets of $957.4
million on September 30, 1998. Thus, despite declining asset prices during this
period, the Fund experienced a net growth of 14.0% in its net assets in the
third quarter, which stood at $840.2 million on June 30, 1998.
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 principal investments of the
Series are a fully replicating portfolio of all 500 stocks in the Index and a
long position in S&P 500 futures contracts, which are used to quickly convert
most daily cash flows into the Series into equity exposure. At the end of
September, the Series' equity portfolio was valued at $991.1 million, and the
Series held a long position in December 1998 futures contracts. As always, it is
the Fund's goal to be 100% invested in the S&P 500 Index at all times.
During the September quarter, composition change activity in the S&P 500
continued at a brisk pace. As a result, the Series added the following equities
to its portfolio: Fred Meyer Inc. Holding Co., Dollar General Corp., Waste
Management Inc., Electronic Data Systems Corp., Kohl's Corp., Regions Financial
Corp., Provident Company, Inc., RJR Nabisco Holdings Corp., HCR Manor Care Inc.,
BMC Software Inc., Union Planters Corp., AES Corp., Peoplesoft Inc. and Paychex
Inc.
Merrill Lynch Small Cap Index Fund
For the quarter ended September 30, 1998, Merrill Lynch Small Cap Index Fund's
Class A and Class D Shares had total returns of -20.05% and -20.08%,
respectively. Since inception (April 9, 1997) through September 30, 1998, the
Fund's Class A and Class D Shares had total returns of +6.04% and +5.69%,
respectively. The Fund's benchmark, the unmanaged Russell 2000 Index, had total
returns of -20.15% for the quarter ended September 30, 1998 and +6.77% since
inception through September 30, 1998.
Small-capitalization stocks continued to suffer one of their worst declines in
history on both an absolute basis and relative to larger stocks during the
September quarter. The Russell 2000 Index, which had a -4.66% total return for
the quarter ended June 30, 1998, followed with a third quarter of 1998 return of
- -20.15%, as the Index dropped by nearly 100 points. During August, the Index
lost nearly 82 points, but recovered somewhat during the markets' broad-based
recovery in September, which cushioned some of the impact of the August decline.
From its high of 491.14 on April 21, 1998, the Russell 2000 had lost more than
153 points to close at 337.95 on August 31, 1998, an incredible decline of
31.19% in a little over four months. Despite the strong showing of technology
and health care stocks during September, no sector of the Russell 2000 had
positive returns for the third quarter. On a year-to-date basis ended September
30, 1998, the Russell 2000 utilities sector was the only group with a positive
return (+0.01%), with every other sector showing double-digit declines, led by
the energy sector's decline of 40.79%. Cash flow activity for Merrill Lynch
Small Cap Index Fund was exceedingly light throughout the September quarter. The
main impact on the Fund's net assets came from tumbling equity prices. Net
assets ended the September quarter at $31.1 million. This compares with the
Fund's net assets of $41.1 million on June 30, 1998 and represents a decrease of
24.3%.
In Conclusion
We appreciate your investment in Merrill Lynch Index Funds, Inc., and we look
forward to assisting you with your investment needs in the months and years
ahead.
Sincerely,
/s/ Terry K. Glenn
Terry K. Glenn
President
/s/ Jay C. Harbeck
Jay C. Harbeck
Senior Vice President and
Co-Portfolio Manager
Merrill Lynch Aggregate Bond Index Fund
/s/ Jeffrey B. Hewson
Jeffrey B. Hewson
Senior Vice President and
Co-Portfolio Manager
Merrill Lynch Aggregate Bond Index Fund
/s/ Gregory Mark Maunz
Gregory Mark Maunz
Senior Vice President and
Co-Portfolio Manager
Merrill Lynch Aggregate Bond Index Fund
/s/ Eric S. Mitofsky
Eric S. Mitofsky
Senior Vice President and
Portfolio Manager
Merrill Lynch International Index Fund
Merrill Lynch S&P 500 Index Fund
Merrill Lynch Small Cap Index Fund
November 3, 1998
4 & 5
<PAGE>
Merrill Lynch Index Funds, Inc., September 30, 1998
PERFORMANCE DATA
About Fund Performance
Investors are able to purchase shares of the Fund through the Merrill
Lynch Select PricingSM 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 "Recent Performance Results" and
"Average Annual 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>
Standardized
12 Month 3 Month Since Inception 30-Day Yield
Total Return Total Return Total Return As of 9/30/98
========================================================================================================================
<S> <C> <C> <C> <C>
ML Aggregate Bond Index Fund Class A Shares* +11.33% +4.21% +18.48% 5.46%
- ------------------------------------------------------------------------------------------------------------------------
ML Aggregate Bond Index Fund Class D Shares* +11.06 +4.15 +18.04 5.22
- ------------------------------------------------------------------------------------------------------------------------
Lehman Brothers Aggregate Bond Index** +11.51 +4.23 +19.04 --
========================================================================================================================
</TABLE>
* Investment results shown do not reflect sales charges; results shown would
be lower if a sales charge was included. Total investment returns are
based on changes in net asset values for the periods shown, and assume
reinvestment of all dividends and capital gains distributions at net asset
value on the payable date. The Fund commenced operations on 4/03/97.
** This unmanaged market-weighted Index is comprised of investment-grade
corporate bonds (rated BBB or better), mortgages and US Treasury and
Government agency issues with at least one year to maturity. Since
inception total return is from 4/03/97 to 9/30/98.
International Index Fund
Recent Performance Results
<TABLE>
<CAPTION>
12 Month 3 Month Since Inception
Total Return Total Return Total Return
=========================================================================================================================
<S> <C> <C> <C>
ML International Index Fund Class A Shares* -3.21% -14.69% +12.76%
- -------------------------------------------------------------------------------------------------------------------------
ML International Index Fund Class D Shares* -3.42 -14.76 +12.42
- -------------------------------------------------------------------------------------------------------------------------
MSCI EAFE Index--GDP Weighted** -2.49 -14.50 + 9.74
=========================================================================================================================
</TABLE>
* Investment results shown do not reflect sales charges; results shown would
be lower if a sales charge was included. Total investment returns are
based on changes in net asset values for the periods shown, and assume
reinvestment of all dividends and capital gains distributions at net asset
value on the ex-dividend date. The Fund commenced operations on 4/09/97.
** This unmanaged gross domestic product-weighted Index is comprised of
equity securities of companies from various industrial sectors whose
primary trading markets are located outside the United States and which
are selected from among the larger-capitalization companies in such
markets. Since inception total return is from 4/30/97 to 9/30/98.
S&P 500 Index Fund
Recent Performance Results
<TABLE>
<CAPTION>
12 Month 3 Month Since Inception
Total Return Total Return Total Return
=========================================================================================================================
<S> <C> <C> <C> <C>
ML S&P 500 Index Fund Class A Shares* +8.65% -10.04% +38.20%
- -------------------------------------------------------------------------------------------------------------------------
ML S&P 500 Index Fund Class D Shares* +8.44 -10.12 +37.71
- -------------------------------------------------------------------------------------------------------------------------
S&P 500 Index** +9.05 - 9.95 +38.90
=========================================================================================================================
</TABLE>
* Investment results shown do not reflect sales charges; results shown would
be lower if a sales charge was included. Total investment returns are
based on changes in net asset value for the periods shown, and assume
reinvestment of all dividends and capital gains distributions at net asset
value on the ex-dividend date. The Fund commenced operations on 4/03/97.
** This unmanaged broad-based Index is comprised of common stocks. Since
inception total return is from 4/03/97 to 9/30/98.
Small Cap Index Fund
Recent Performance Results
<TABLE>
<CAPTION>
12 Month 3 Month Since Inception
Total Return Total Return Total Return
=========================================================================================================================
<S> <C> <C> <C>
ML Small Cap Index Fund Class A Shares* -19.49% -20.05% +6.04%
- -------------------------------------------------------------------------------------------------------------------------
ML Small Cap Index Fund Class D Shares* -19.69 -20.08 +5.69
- -------------------------------------------------------------------------------------------------------------------------
Russell 2000 Index** -19.02 -20.15 +6.77
=========================================================================================================================
</TABLE>
* Investment results shown do not reflect sales charges; results shown would
be lower if a sales charge was included. Total investment returns are
based on changes in net asset value for the periods shown, and assume
reinvestment of all dividends and capital gains distributions at net asset
value on the ex-dividend date. The Fund commenced operations on 4/09/97.
** This unmanaged Index is comprised of approximately 2,000
smaller-capitalization common stocks from various industrial sectors.
Since inception total return is from 4/09/97 to 9/30/98.
Aggregate Bond Index Fund
Average Annual Total Return
% Return
================================================================================
Class A Shares
================================================================================
Year Ended 9/30/98 +11.33%
- --------------------------------------------------------------------------------
Inception (4/03/97) through 9/30/98 +12.03
- --------------------------------------------------------------------------------
% Return
================================================================================
Class D Shares
================================================================================
Year Ended 9/30/98 +11.06%
- --------------------------------------------------------------------------------
Inception (4/03/97) through 9/30/98 +11.75
- --------------------------------------------------------------------------------
International Index Fund
Average Annual Total Return
% Return
================================================================================
Class A Shares
================================================================================
Year Ended 9/30/98 -3.21%
- --------------------------------------------------------------------------------
Inception (4/09/97) through 9/30/98 +8.47
- --------------------------------------------------------------------------------
% Return
================================================================================
Class D Shares
================================================================================
Year Ended 9/30/98 -3.42%
- --------------------------------------------------------------------------------
Inception (4/09/97) through 9/30/98 +8.25
- --------------------------------------------------------------------------------
S&P 500 Index Fund
Average Annual Total Return
% Return
================================================================================
Class A Shares
================================================================================
Year Ended 9/30/98 + 8.65%
- --------------------------------------------------------------------------------
Inception (4/03/97) through 9/30/98 +24.20
- --------------------------------------------------------------------------------
% Return
================================================================================
Class D Shares
================================================================================
Year Ended 9/30/98 + 8.44%
- --------------------------------------------------------------------------------
Inception (4/03/97) through 9/30/98 +23.90
- --------------------------------------------------------------------------------
Small Cap Index Fund
Average Annual Total Return
% Return
================================================================================
Class A Shares
================================================================================
Year Ended 9/30/98 -19.49%
- --------------------------------------------------------------------------------
Inception (4/09/97) through 9/30/98 + 4.05
- --------------------------------------------------------------------------------
% Return
================================================================================
Class D Shares
================================================================================
Year Ended 9/30/98 -19.69%
- --------------------------------------------------------------------------------
Inception (4/09/97) through 9/30/98 + 3.82
- --------------------------------------------------------------------------------
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--9/98
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