Index investing: Is it right for you?

Mutual funds are characterized by the types of investments they hold and the strategies they use. Some funds are designed to match a major market index, based on the belief that the odds of beating the market are small to none. Other funds strive to outperform the market by having a portfolio manager at the helm, selecting which assets to buy, sell, or hold.

In 2004, for example, 62 percent of actively managed large-cap blend funds (which hold both growth and value stocks) failed to beat the S&P 500 Stock Index, according to Morningstar, the Chicago-based stock and mutual fund tracker. Sixty-three percent have underperformed over the past three years through 2004, and 82 percent have lagged behind over the past 10.

Still, many investors favor actively managed funds. Why else would there be almost 6,000 actively managed funds vs only about 400 index funds? "It's the nature of mankind to be hopeful and optimistic," says John Eckel, president of Pinnacle Investment Management in Simsbury, CT. "With an actively managed fund you hope you can be the investor who beats the market."

Given the historical performance record, though, perhaps it's time to follow the adage-if you can't beat 'em, join 'em-and replace one or more of your actively managed funds with an index mutual fund or an exchange traded fund (ETF), another type of index product that's becoming increasingly popular.

The standard index fund invests in all, or a large representative sample of, the securities comprising a market index-the S&P 500, Dow Jones Industrial Average, Russell 1000, etc.-and in the same proportions, or "weightings," as those securities occupy in the index. An ETF, on the other hand, is a basket of index securities that trades like a stock on an exchange. Unlike a mutual fund whose shares are priced once daily, after the market closes, an ETF can be bought or sold throughout the trading day. It's like buying a share of stock, except that single share contains a selection of equities. There are about 150 ETFs, with total assets of $222 billion. Index equity funds, by comparison, have more than three times that amount.

Both index funds and ETFs come in many varieties: large cap, small-cap, mid-cap, international, and market sector (healthcare, financial services, utilities, etc.). There are also those that track certain bond indexes. Although some say the case for indexing isn't compelling for small- and mid-cap funds, Morningstar data show the opposite: Actively managed small-cap and mid-cap funds, especially value funds looking for bargain-priced stocks, usually lag their respective indexes.

Where should you start? If you're buying an index investment for the first time, you might consider one that tracks a broad-based stock market index, such as the S&P 500, which many market gurus favor as a core portfolio holding. Later you can consider replacing some of your actively managed funds in certain asset classes with index funds or ETFs that cover the same investment ground.

Whether you'll decide to go with a standard index mutual fund or an ETF will depend on a number of factors. Let's look at each type of investment in turn.