Getting Started in Index Funds
Given our constant focus on the virtues of Upgrading, it may not be obvious that we're actually big fans of index funds as well. One of our model portfolios—Just-the-Basics—is based almost exclusively on their use. Generally speaking, we believe that if you can't Upgrade (for example, within a retirement plan that doesn't offer many fund choices), your next best course of action is to use index funds. For those that aren't familiar with index funds, here's a brief discussion of their strengths and weaknesses.
First, let's make sure you understand what we're talking about. An index fund is a special kind of mutual fund that has only one objective: to mirror the performance of a market index, such as the Standard & Poor's 500 stock index. The portfolio manager invests only in the securities that are used in calculating the index. The fund will make or lose money to the same extent the index on which it is patterned shows gains or losses. For example, if the S&P 500 gains 15% in a given year, then any S&P 500 index fund should also gain about 15% that year. From an investing point of view, what could be simpler? Now, here are some of the advantages they offer:
• To guard against sub-par investment returns. Index funds help assure that your results are in line with those of the general market.
• Lower expenses. Index funds have very low operating expenses and transaction costs. The overhead of Vanguard's index funds runs less than 0.25% per year, about one-sixth of what a typical stock fund might incur.
• Fewer taxable distributions. Index funds require only minimal trading in the portfolio. This reduces the amount of capital gains taxes, a significant advantage if you're investing taxable dollars, i.e., outside a tax-deferred retirement account.
• Easy accessibility. Index funds are increasingly being offered in 401(k)s and retirement plans. Most such plans commonly offer at least one index fund focused on a large-company stock index (like the S&P 500) and one focused on a small-company stock index (like the Russell 2000 or S&P 600). Many go beyond this, offering index funds that track foreign funds, medium-sized companies, and other market segments. The inclusion of these funds makes it easier to include your retirement assets in your overall allocation strategy.
Index funds also have disadvantages, some of which were exposed during the last bear market. Their performance during 2000-2003 took some of the luster off indexing, though it remains extremely popular. Indexing's disadvantages include:
• No protection during periods of market weakness. They are fully invested in a portfolio of stocks which reflects the index they are designed to mimic, and they stay fully invested at all times. Because they're on automatic pilot, they're called "passively-managed" funds. The managers of "actively-managed" stock funds, on the other hand, can take pro-active defensive measures like increasing their holdings of cash or high dividend-paying stocks. Such efforts may or may not help cushion the fall, but at least the managers are free to try.
• More narrowly targeted. By that we mean they invest only in securities that are part of the index they are imitating. An S&P 500 fund, for instance, invests only in the large companies that comprise that index. This means it owns no small companies or foreign stocks. When large company stocks do well, so will an S&P 500 index fund. When stocks of small companies are in favor, as they have been over most of the past decade, an S&P 500 index fund will be a relatively poor performer compared to a Russell 2000 or Wilshire 4500 index fund.
For example, Money magazine reported last year that 2005 was the 7th straight year that the average actively-managed fund had outperformed the S&P 500 index. However, all this really proves is that the S&P 500 is too narrowly targeted to be used as the sole holding in an indexing strategy. Changing the comparison so that each actively-managed fund was matched against an appropriate index fund based on its risk category is telling—the index funds beat 74% of the actively-managed funds. So indexing clearly works; the lesson is simply that a single S&P 500 index fund is insufficient to capture the entire market's returns.
To compensate for this, our Just-the-Basics strategy uses several funds, including those that invest in small companies, foreign stocks, and bonds. Level 3 investors interested in an indexing strategy need not wait until they have the $25,000 recommended for a Level 4 strategy—our Getting Started 
portfolios can guide you to an efficient indexed portfolio even if you have significantly less to invest. Vanguard's LifeStrategy Growth (VASGX) is also a good option; it combines several index funds into one portfolio, with a low minimum of just $3,000.
Indexing isn't an all or nothing proposition. Many investors, including sophisticated institutions, invest 50%-75% of their money in index funds, using them as "core" positions to anchor their portfolios. With their remaining money, they venture into other more adventurous holdings! (SMI's Enhanced Just-the-Basics strategy offers a low-maintenance version of this type of approach.) 
- Using the 401(k) Fund Tracker to Evaluate Index Funds
- SMI's Just-the-Basics strategy
- SMI's Getting Started strategy
- SMI's Enhanced Just-the-Basics strategy
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