An effortless way to play the market

Index funds boast low expenses, and they guarantee you'll do about as well as the markets they track. But they have downsides.

By Leslie Kane
Senior Editor

FP Thomas M. Chin has found a way to cut investment risk while keeping up with the stock market. Three years ago, the Ivor, VA, physician moved about 70 percent of his mutual fund holdings into Vanguard 500 Index Fund, Vanguard Extended Market Index Fund, and Vanguard Balanced Index Fund, which tracks the US bond market as well as equities. He kept the rest of his money in actively managed funds.

His index funds have since produced annualized returns of 19.9 percent. (All returns in this article are through Jan. 31, 2000.) Although his actively managed funds have done better—27.9 percent—Chin remains a die-hard index fund proponent. "I pretty much kept up with the market and, thanks to the index funds, I did it with minimal risk," he says.

He's not the only member of the fan club. "Index funds provide a low-risk, low-cost, and tax-efficient way to invest," says W. Scott Simon, an investment adviser in Camarillo, CA, and author of Index Mutual Funds: Profiting From an Investment Revolution (Namborn Publishing, 1998). "Consumers may overlook these funds, which aren't as exciting as those that try to outperform the market. But index funds often do better than actively managed funds, which also have higher expenses."

Index funds aim to match market averages by tracking a variety of indexes, such as the Standard and Poor's 500 Stock Index; the Wilshire 5000 Total Market Index, which includes virtually all US stocks; the Russell 2000 Index of small-cap stocks; the PSE (Pacific Stock Exchange) Technology 100 Index; and the Morgan Stanley Capital International Indexes of foreign stocks. Index fund managers buy a sample of stocks in the index, keeping the same proportion of company sizes and sectors.

More than 260 index funds are available, up from about 100 in 1996, and almost 8 percent of total mutual fund net assets—$362 billion—are in such funds. In fact, Vanguard 500 Index Fund, with more than $105 billion in net assets, now almost ties Fidelity Magellan as the world's biggest mutual fund.

With index funds, you don't have to worry about a manager's poor judgment, but you still face market risk. If the market your fund tracks does poorly, so will your fund. But that doesn't worry index fund aficionados. "The advantages clearly outweigh the negatives," says Peter Crane, author of Mutual Fund Investing on the Internet (Academic Press, 1997). "You should use index funds for the bulk of your portfolio."

Maybe. But let's take a closer look at index and actively managed funds and see where each type shines.

Returns. Index fund admirers will tell you that it's easy to choose one that beats most actively managed funds. And in recent years, it has been. For instance, Vanguard Mid Capitalization Index Fund, Fidelity Spartan Total Market Index Fund, and Main Stay Equity Index Fund have outperformed more than 50 percent of US equity mutual funds over the past year.

That makes managers of traditional mutual funds squirm. "Portfolio managers often claim to have a special talent that enables them to beat the market, but they rarely do," says Jeffrey Troutner, an investment adviser in San Anselmo, CA, and editor of IndexFunds.com, a Web site devoted to index issues.

"You're more likely to underperform the market with an active fund than an index fund," adds Troutner. "Even if you have a great portfolio manager, he could leave. His replacement might have less skill or a different philosophy, in which case the fund will suffer."

But not everyone agrees with Troutner. Proponents of actively managed funds point out that the index funds that did best over the past three years were mostly those that tracked the S&P 500, composed of large-cap stocks. If the S&P 500 declines in coming years, as some experts predict, and small- and mid-caps rise, actively managed funds could look much better.

"Index funds are fine when the market's up, but if the market stays flat, investors will lose their enthusiasm for them and will appreciate actively managed funds," says Thomas Dillman, equity research director at State Street Research in Boston. "In a stagnant market, active managers can find good stocks, take concentrated bets, and beat the indexes."

Adds Jim Stetler, a member of Vanguard's Core Management Group in Malvern, PA, who manages both active and index funds: "Actively managed funds give you the opportunity to outperform the market. However, identifying an actively managed fund that consistently beats its benchmark is no easy task."

For those fortunate enough to find such a fund, though, the payoff can be substantial. Even in today's ebullient market, some actively managed portfolios' recent returns have shamed the index funds. A couple of the many examples: Janus Fund boasts one- and three-year returns of 35.1 and 33.9 percent, respectively, and Van Kampen Aggressive Growth Fund—Class A has returned 107.6 and 51.9 percent. The corresponding S&P 500 Stock Index returns are 10.4 and 22.9 percent. In all, more than 750 actively managed US equity funds have done better over the past three years than the S&P 500. And, thanks to Morningstar and information readily available on the Internet, those superior funds aren't tough to find.

True, index fund returns are more predictable than those of actively managed funds. "You know your S&P 500 index fund will rise and fall with the index; you don't know whether an active fund will do much better or much worse," says Stetler. Still, index funds are no sure thing, and a shot at great returns might be worth the added uncertainty that goes with actively managed funds.

Diversification. Actively managed funds often focus on hot sectors or powerhouse companies. Index funds that cover the market provide a more balanced sampling. For example, Vanguard Total Stock Market Index Fund, which tracks the Wilshire 5000, contains more than 3,300 stocks. "You can't get more diversified than that," says Simon. "You get small- and mid-cap companies that are absent from the S&P 500."

An index fund that includes small businesses puts you in new companies that may someday prove as successful as Microsoft. And its diversification among industries provides another benefit: "Growth and technology stocks are doing well now, but as a different sector comes back, you'll be in it, too," says Peter Crane. An actively managed small-cap fund covers new companies, too, but not with the same breadth that a total market index fund provides.

On the other hand, while diversification lowers risk, it also means you won't enjoy the full benefits if one sector takes off. Shareholders of RS Diversified Growth Fund, with one- and three-year annualized returns of 139.0 percent and 54.9 percent, respectively, aren't complaining about the portfolio's lack of diversification (despite its name). The small-cap fund soared partly because of its focus on technology and service companies.

"Many people are overdiversified," says Richard Rodman, a financial adviser in Westfield, NJ. "In an index fund, the returns gravitate toward mediocrity. Concentration lets you zero in on good stocks and do better than a broader fund can do."

Expenses. Since index fund managers take stocks from the index, the portfolios don't need stock pickers or as many analysts. That keeps expenses down. The average expense ratio for the 262 index funds tracked by Morningstar is 0.64 percent, and Vanguard 500 Index Fund's expense ratio is a mere 0.18 percent. For actively managed equity mutual funds, the average is 1.58 percent.

But look further. Some actively managed funds have expense ratios of 0.75 percent or less—not much more than some index funds. To many investors, a shot at higher returns is worth paying a little more for expenses.

Turnover. Index funds are far superior to actively managed ones with regard to turnover—trading assets—which can erode profits. Selling profitable holdings in a fund can create taxable income. In their efforts to beat the market, managers of actively managed funds may buy and sell frequently to lock in profits and grab another shooting star. Index fund managers generally trade only when the index components change. Average annual index fund turnover is only 25 percent; for actively managed equity funds, it's 91 percent.

Your investment goals. Given all the pros and cons, it would be foolish to flatly proclaim that index or actively managed funds are superior. What's best for you depends on your personality, situation, and goals.

Index funds make sense for several types of people: those who want to spend as little time as possible managing their investments, those who prefer the security of knowing they'll match an index to the added risk that goes with trying to beat it, and those who want to hedge their bets on actively managed funds.

If you're a conservative investor or just want to put your portfolio on autopilot, place the equities portion of your holdings in a fund that tracks the total stock market, and sit back. Or get an instant portfolio of index funds with Fidelity Four-in-One Index Fund, which allocates your money to Fidelity Spartan Market Index Fund, Fidelity Spartan Extended Market Index Fund, Fidelity Spartan International Index Fund, and Fidelity US Bond Index Fund. (The Four-in-One fund is less than a year old, but two of its underlying portfolios have been around for two years, the other two for 10.)

Suppose you're a more sophisticated investor but still don't want actively managed funds. Then select index funds from a variety of indexes. If you're itching to do better, combine active and passive funds.

"Index funds would make an excellent core portfolio," says Stetler. "Use a single total-market fund, or break the equity market into large-, mid-, and small-cap indexes and choose an actively managed and an index fund in each category. That way, each segment can capture market growth and also have a chance to beat the market."

For an extra kick, add a technology index fund, such as Principal Preservation Portfolios PSE Tech 100 Index Portfolio—Class A, which follows the PSE Technology 100 Index.

Choosing an index fund

Once you've decided that index funds are for you, the next step is deciding which to buy. Some index funds perform so similarly, you may as well throw a dart to choose. Others that track the same index get different returns. For example, Vanguard Small Capitalization Index Fund and Merrill Lynch Small Cap Index Fund—Class D Shares both follow the Russell 2000 Index. Twelve-month returns for these funds are 19.6 and 17.2 percent, respectively.

Why the disparity in returns between funds tracking the same index? Because index fund managers aren't completely passive. Their funds rarely contain every stock in the benchmark. Merrill Lynch Small Cap Index Fund—Class D, for instance, follows the Russell 2000, but the fund contains only about 1,300 stocks. The manager must select the stocks he includes, and that can skew the results.

"Investment companies may define 'small stock' differently, which changes the weighting of small-, medium-, and large-cap stocks in each index portfolio," says W. Scott Simon, an investment adviser in Camarillo, CA. "That would affect performance." So check how closely a fund's one- and three-year returns parallel its benchmark. Make sure you compare the fund with the appropriate index, and read the prospectus to see how closely the fund aims to track its index.

Also weigh 12b-1 fees, which cover marketing and distribution costs. And, if possible, stay away from an index fund with a front-end sales charge. In most cases, you can get a comparable fund without one.

Most of the following funds are no-load. All have expense ratios far below those of most actively managed funds, are directly available to all investors, and came within three points of their benchmarks for one-, three-, and five-year annualized time periods. Some, such as Vanguard Small Capitalization Index Fund, even beat their benchmarks.

Leslie Kane. An effortless way to play the market.

Medical Economics

2000;6:75.