How to Pick the Best Index Funds

It’s a straightforward strategy: Track a broad swath of the market by buying shares in a low-cost index fund. But it’s hardly the new, new thing; the country’s first index mutual fund, Vanguard 500 Index, opened in 1976. Yet indexing has never been more popular, and the numbers of distinct benchmarks and the funds that track them have swelled. There are now 1,732 index portfolios, compared with 419 a decade ago. Meanwhile, assets in stock index funds have grown 70% over the past five years, to $2 trillion, and cash in bond index funds has more than doubled, to $510 billion. Over the same period, money invested in actively managed U.S. stock portfolios has shrunk by 18%.

SEE ALSO: 8 Great Dividend Mutual Funds

What’s the attraction? Performance, of course. Index mutual funds and their brethren, exchange-traded funds, have done better than most actively managed funds over time. For example, Vanguard 500 Index (symbol VFINX), which mirrors Standard & Poor’s 500-stock index, has outpaced 80% of all actively managed large-company, U.S.-oriented stock funds over the past three years.

Expense advantage

Index funds have other draws. Most important, they’re cheap. Vanguard Total Stock Market Index (VTSMX), the largest index mutual fund, charges just 0.17% per year. The expense ratio for the ETF version of the fund, Vanguard Total Stock Market ETF (VTI), is a mere 0.06%. (ETFs are baskets of securities that trade on exchanges just like stocks.) By contrast, the average expense ratio for actively managed U.S. stock funds is 1.32%.

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Another plus for index funds: When you buy one, you pretty much know what you’re getting. The holdings in an index fund, which are clearly defined by the rules of the benchmark, are transparent. “Investors want more clarity about what they’re investing in,” says Matt Tucker, of iShares. (Actively managed mutual funds disclose portfolio holdings only once a quarter.) Combine all of that with a higher level of fear following the cataclysm of 2008 and you have skittish investors fueling an indexing boom.

But don’t rush to brush off all actively managed funds. Although the typical active large-company U.S. stock fund lagged Vanguard Index 500 over the past one, three, five and ten years, “above average” funds fared better, according to a new Morningstar study. (Morningstar defined above-average funds as those with low fees and long manager tenure, among other things.) In fact, cheap actively run funds (defined as those with expense ratios in the bottom 25%) beat Vanguard 500 over the past ten, 15 and 20 years. The takeaway: “It is possible to find actively managed funds that outperform” their benchmarks, says Morningstar analyst Dan Culloton. “But you must have patience and discipline to stick by those funds over time.”

Dodge & Cox Stock is a case in point. A member of the Kiplinger 25, it beat the S&P 500 for five consecutive calendar years in the early and mid ’00s, and investors poured money into the fund. But Stock stumbled in 2007 and 2008, after which “people couldn’t get out of it fast enough,” says Culloton. The fund performed well in 2009 and 2012, however, and its ten- and 15-year returns now beat those of the S&P 500. Helping the fund deliver strong long-term results is an unusually low expense ratio (for an actively managed fund) of 0.52% annually.

We believe there’s a place in every portfolio for passively managed index funds or ETFs (or both) and actively managed mutual funds. “It doesn’t have to be either-or,” says Culloton. It can make sense, he says, to use index products in asset classes, such as large-company U.S. stocks, that are considered more efficient. Hire active managers for the less-efficient pockets of the market, such as stocks of tiny companies, known as micro caps, and emerging markets.

That’s how the folks at Kanaly Trust, a Texas financial adviser, manage their clients’ money. They use index funds or ETFs except in certain asset classes, such as emerging markets or municipal bonds, in which they think an active manager can make a difference. Says chief investment officer James Shelton: “If we can find an actively managed fund that has outperformed over a long period of time, and that outperformance exceeds the higher fee we have to pay for it, then why wouldn’t we invest in it?”

Another way to go is “core and explore,” says Culloton. Build a core portfolio of index funds—domestic stock, international stock, and bond index funds, for instance—and complement it with funds that have managers who you think can beat the market. “The index funds control risk by ensuring that part of your portfolio is getting the market return minus costs. The active funds give you a shot at outperformance over the long term,” Culloton says. Or round out your core portfolio with small bets in index funds that focus on riskier asset classes, such as an ETF that owns Japanese stocks or an index fund that specializes in biotech stocks.

Picking the right fund

In the old days—say, a dozen years ago—choosing an index fund was a relative slam-dunk. All you had to do was to find a reliable company with experience running index funds, aim for low fees and stick with a fund designed to match a broad, well-known index, such as the S&P 500 or the Dow Jones industrial average. Now, with the explosion of index funds, especially in the ETF format, picking a simple index fund is, well, not so simple.

For starters, be sure you understand what kind of index fund you’re buying, the rules that govern its underlying holdings and how it has behaved in past markets. The more narrow or specialized the index, the more wary you need to be. Just because there’s an ETF that focuses on Chinese banks—Global X China Financials (CHIX)—doesn’t mean you should invest in it.

To make the search process easier, we divide the index-fund universe into five categories. At the end of each group, we list the best bets.

Traditional index funds

These track well-known benchmarks, such as the S&P 500, the Dow industrials, the MSCI EAFE index (stocks in developed foreign markets), the Russell 2000 index (small-company stocks) and Barclays Capital Aggregate Bond index (high-quality U.S. bonds). Use funds and ETFs that track these indexes to establish core positions or even to construct an entire portfolio.

Best bets. Vanguard Index 500 (VFINX); Vanguard Total Stock Market Index (VTSMX); PowerShares QQQ (QQQ), which tracks the Nasdaq-100 index; and iShares Core Total U.S. Bond Market (AGG). On the international side, Vanguard Total International Stock Market ETF (VXUS) and iShares MSCI Emerging Market Index (EEM).

Traditional indexes, sliced and diced

These days, you can buy wedges of nearly any broad-based index. Among the most popular are ETFs that home in on dividend-paying companies, such as SPDR S&P Dividend (SDY). Are small-company value stocks your thing? Try iShares Russell 2000 Value (IWN) or its twin from Vanguard (VTWV). Sectors? From the broad—utilities or technology, say—to the narrow—biotechnology or airlines, for example—there’s no limit to the choices. Even bond indexes have been carved up. You can invest in indexes that track emerging-markets corporate or government bonds, as well as corporate bonds in specific sectors, such as financials, utilities or industrials.

Best bets. SPDR S&P Dividend, Technology Select Sector SPDR (XLK), SPDR S&P Biotech (XBI) and PowerShares Emerging Markets Sovereign Debt (PCY).

Designer indexes

Traditional benchmarks, such as the S&P 500 and Russell 3000, weight companies according to their stock-market value. In a designer index, market capitalization takes a back seat to other measures. Some funds (such as WisdomTree ETFs) emphasize a company’s dividend payments. Others, such as the RAFI indexes from Research Affiliates, stress fundamental factors such as a com­pany’s dividends, cash flow, sales and book value (assets minus liabilities).

Best bets. PowerShares FTSE RAFI U.S. 1000 (PRF) and WisdomTree LargeCap Dividend (DLN).

Commodities

These funds track the price of a particular commodity instead of an index. To do so, some exchange-traded products, such as iShares Gold Trust (IAU), buy and store the actual material. Invest in IAU and you own a bit of the fund’s hoard. In other cases, however, ETFs can’t buy the actual stuff. United States Oil Fund (USO), for instance, tries to track the spot price of light, sweet crude oil by buying oil-futures contracts. But because of quirks in the trading of futures contracts, USO has done a poor job of achieving its goal.

Best bet. iShares Gold Trust, as a hedge against global turmoil, a falling dollar and the threat of future inflation.

Leveraged or inverse indexes

Bullish on India? Direxion Daily India Bull 3X Shares (INDL) might catch your eye. The ETF promises to triple the daily return of the index of Indian stocks it tracks. But the key word is daily. Because of the oddities of daily compounding, this ETF and others that seek to deliver a multiple of an index’s return can wreck your portfolio. Over the past 12 months, for instance, the MSCI India index rose 18.4%, but INDL sank 13.0%. “Leveraged ETFs are not buy-and-hold vehicles,” says Kanaly Trust’s Shelton. Inverse funds are also dangerous—whether they seek to simply deliver the opposite of an index, or two or three times the opposite—because of the problem of daily compounding.

Best bets. None.