Mutual Funds

Good News About Index Funds

Funds that merely mimic the market did better than expected during the downturn. They're also attracting gobs of cash.

By Bob Frick, Senior Editor

From Kiplinger's Personal Finance magazine, September 2009

Relax, indexers. your strategy weathered the Great Crash just fine.

Actually, telling index-fund investors to relax is like telling the Rock of Gibraltar to stand still. When the market nose-dived last fall and investors rushed to get their cash out of actively run funds, devotees of index funds kept pouring money in. Fund consultant Strategic Insight found that investors put $200 billion into stock and bond index funds last year -- an amount that was actually up from 2007. Meanwhile, investors withdrew more than $200 billion from actively managed funds. All told, individual investors have about $604 billion in stock and bond index funds, according to the Investment Company Institute.

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That isn't to say that index funds fared well in the bear market; virtually all stock funds took a licking. But the perseverance of indexers gets to the heart of the strategy, which is as much a mind-set as it is a way to own stocks and bonds. The classic indexer is satisfied with beating most comparable funds over time and happily abdicates responsibility for handicapping the talents of fund managers. "Index investors believe in long-term, buy-and-hold investing" and tend not to succumb to the temptation of chasing the hot fund du jour, says Gus Sauter, chief investment officer of the Vanguard Group, a fund family that helped pioneer index funds.

Index funds are simply low-cost mutual funds that seek to mimic a market benchmark -- such as Standard & Poor's 500-stock index, which measures the performance of big U.S. companies. You can buy a fund run by people who try to beat an index by picking stocks or bonds (sometimes both) that they believe will do better. But you'll pay total fees that, in the case of domestic, large-company funds, average 1.27% a year. By contrast, Vanguard 500 Index, the largest index mutual fund, charges just 0.16% of assets per year. S&P 500 index funds targeted to investors of modest means from Fidelity and Schwab charge even less.

The link between expenses and performance is incontrovertible, as data prepared for Kiplinger's by Morningstar shows. For example, returns of the most-expensive actively managed small-company funds (the 25% of such funds with the highest fees) lag those of the least-expensive funds (the 25% with the lowest expenses) by an average of 1.8 percentage points per year. As for big-company-stock funds, cheap S&P 500 index funds beat 69% of actively managed funds for the 15-year period that ended June 30. However, most big-company, active funds beat the index over the past ten years. One reason is that some of the most influential stocks in the S&P 500, including General Electric and Pfizer, performed miserably over the past decade after experiencing huge run-ups in the 1990s.

Although only 11% of mutual fund assets are in index funds, the proportion is rising. And a recent survey of institutional investors (such as pension funds and endowments) by Greenwich Associates found that one in five had moved money from actively managed funds to index funds in the past year. Chris McNickle, managing director of Greenwich Associates, says that "in a market where some active managers underperformed spectacularly, many institutions are seeking the predictability of index funds."

This is happening despite actively managed, big-company stock funds having fared slightly better than index funds during the 2007-09 bear market (in other categories, index funds prevailed). Did this deal a blow to the index strategy? Not really, says Sauter. Such a narrow slice of time proves nothing to long-term investors. He points out that in any given year, index funds may lose to actively managed funds in half the investment styles (for example, small-company growth or large-company value).

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