The Upside of Index Funds

A stock fund investor faces a fundamental decision when choosing an investment strategy: "Will I try to beat the market or just try to match the market?"

Attempting to beat the market requires using actively-managed funds — that is, funds that buy and sell stocks regularly in an attempt to hold only those stocks that are the best performers. (All funds recommended in our Fund Upgrading strategy are actively managed.)

In contrast, matching the market can be done using passively managed "index" funds. These funds make no attempt to discern how specific stocks will perform, opting instead to simply buy the entire group of stocks included in a particular stock market index, such as the Standard & Poor's 500. (The S&P 500 measures the combined performance of 500 of the largest U.S. companies.) The indexer is willing to accept the "market rate of return" for that index.

Sometimes indexes perform well, sometimes they don't. Over the past 50 years, the average annualized return for the S&P 500 has been pretty solid: roughly 10% per year. But over the past decade, the S&P has returned only about 4% per year.

Even though SMI's actively-managed strategy (Upgrading) has strongly outperformed our indexing strategy (Just-the-Basics) since the late 1990s, an indexing approach is still a good choice for some investors. Here's why:

• Simplicity. Index funds are great for beginners because they are the epitome of "low maintenance." You don't have to know anything about picking funds or about diversification strategies. Just buy a fund such as Vanguard's Total Stock Market Index and — presto! — you own a share in virtually the entire U.S. market. And you don't have to do any monitoring or fine-tuning until it's time for your annual rebalancing (to make sure the stock/bond mix in your whole portfolio is what you want it to be).
• Predictability. You can buy index funds and hold them for years because their performance is predictable — you'll get what the market gives. You know you won't outperform the market, but you also know you won't lag the market. That's more than most fund investors can say, since studies have consistently shown that a majority of actively-managed funds — as many as 80% over some time periods — fail to outperform the market over time. (Even the pros have trouble predicting winners!)
• Availability. Usually, index funds are included as options in company retirement plans. So if you're stuck with only a handful of actively-managed fund choices in your 401(k), an index fund can be quite appealing — especially given the likelihood that most actively-managed funds will end up trailing the market.

IT PAYS TO SHOP AROUND

Because index funds simply "match the market," it may seem as though one index fund is as good as another. That isn't true. Not all index funds are created equal. In particular, there are two factors that affect the comparative performance of index funds.

First, returns will vary based on which target a particular fund is trying to replicate (see table). Only a fund that tracks the entire market (such as the Vanguard Total Stock Market Index fund) will give you the full "market-matching" returns we've been talking about. If matching the market is your goal, stick with that fund, or one like it.

For a little more flexibility, you could choose a combination of funds — such as Vanguard's 500 Index fund paired with its Extended Market Index fund — that together cover the entire market. Buying funds in combination allows you to choose how your overall investment is weighted — either toward larger companies or smaller companies.

If you invest in an index fund that doesn't track the entire market, your returns will reflect only a particular market segment, such as "growth stocks of small companies" or "value stocks of large companies" (for examples, see the table). Returns for a particular market segment may end up being more or less than the overall market. So, before you invest, be sure you understand which segment of the market your index fund is trying to follow.

The second factor that affects a fund's returns is the level of expenses. Even among index funds focused on the same target, returns can vary greatly due to the costs each fund chooses to pass on to shareholders. The best index funds not only closely track their target index, but also keep their fees and overhead costs low.

Vanguard's 500 Index fund, for example, charges just 0.15% per year. Contrast that to the Rydex S&P 500 fund which charges 2.25% annually, with a 1% deferred sales charge to boot — yet this fund invests in the same stocks as the Vanguard 500 fund! Such additional costs add up. $50,000 invested in the Rydex fund will cost you $1,125 per year versus only $75 at Vanguard. (This problem isn't limited to Rydex. High-cost index funds abound.)

THE NEXT STEP

To start an indexing strategy, see our "Getting Started Portfolios"  — or the "Getting Started at Level 3" section in the Fund Performance Rankings (FPR). The material will guide you through the process of selecting funds best suited to your situation.

If you're already invested in index funds —or have index-fund choices in your retirement plan — how can you be sure those funds are good ones? Although we don't include many index funds in our Fund Performance Rankings  report, we do include the Vanguard funds — the "gold standard" of index funds. Therefore, you have a benchmark against which other funds can be judged.

Simply compare the posted returns of your funds against those of the comparable Vanguard funds. If returns are similar over both short and long-term periods, chances are the funds you have — or have access to — are suitable alternatives. If, however, your funds trail the comparable Vanguard index funds by more than .25% per year, it's worth investigating a change.

As we've mentioned before, indexing doesn't have to be an all-or-nothing proposition. Many investors, including large institutional investors, invest 50%-75% of their holdings in index funds, using them as "core" positions to anchor their portfolios. With the rest of their investments, they can venture into "beat the market" type strategies.

These investors know that even if some of their more adventurous holdings go awry, they can rely on the indexes to keep them close to average. In investing, that's not usually a bad place to be.

Mark Biller is Sound Mind Investing's Executive Editor. His writings on a broad range of financial topics have been featured in a variety of national print and electronic media, and he has appeared as a financial commentator for various national and local radio programs. Mark is also the Senior Portfolio Manager of the SMI Funds.

Former SMI staffer Joseph Slife is now the senior producer and co-host of The World & Everything in It, a weekly radio program produced by WORLD magazine that can be heard here. He spent 15 years with Crown Financial Ministries, co-writing articles with Larry Burkett and serving as executive producer for broadcasting.

• SMI's Fund Upgrading strategy
• SMI's Just-the-Basics strategy
• SMI's Enhanced Just-the-Basics strategy

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