Good News About Index Funds

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.

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.

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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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The superiority of index funds over most rivals holds true in the bond market as well. The cost advantage of indexing is particularly important in this category because the returns of bond funds are much more modest than those of stock funds (at least over the long term). Studies by Vanguard and S&P have shown that in some bond categories, only 10% of actively managed funds beat their benchmarks.

Can you pick actively managed funds that will beat their index benchmark over time? Yes, but it's not a simple job, and it takes a lot of time and effort. Investors going the active-management route have to evaluate the funds not only before they buy them but also track changes in management, growth in assets and other variables. (We do the work for you in selecting the Kiplinger 25, top-notch funds with above-average long-term records and below-average costs; see The 25 Best Mutual Funds.)

These, of course, are unusual times. And the bear market has revived the idea that you're better off with active managers during rough stretches. One theory holds that they can sidestep minefields -- for example, shunning bank stocks when the financial system is in disarray. Another says that during a bear market, active managers can move into cash while index funds cannot. A third argument is that in periods of fear and irrational selling, active managers will scoop up ludicrously underpriced securities, giving them an edge over index funds, which are compelled to buy stocks and bonds in proportion to their weighting in the relevant index.

The evidence, though, shows that the bear-market advantage of active funds is an illusion. For example, a study by Vanguard compared the performance of the Wilshire 5000 index, the broadest measure of the U.S. stock market, with that of actively managed funds during six bear markets, the first the one that began in 1973 and the last the one that coincided with the bursting of the technology bubble in 2000. The study found that active managers beat the indexes half the time and trailed them the other half.

But let's assume that most active managers could beat their bogeys during bear markets. Is that helpful? Not really, says Scott Burns, director of exchange-traded-fund analysis at Morningstar (ETFs are almost always index funds; for more on ETFs, see ETF Portfolios for Every Purpose). Burns notes that moving from index funds to actively managed funds in anticipation of a bear market is almost a form of market timing -- something few people can do well (see Can You Time the Market?). "Could you have known when to make the switch away from index funds?" he asks. "And when to switch back?"

Exception to the rule? Many individual investors perceive that index funds lag -- even over time -- in some categories. This is particularly true with regard to small-company stocks. Srikant Dash, global head of research and design for S&P, says that while 20% of individual investors' assets are in index funds, only 5% of that money is in small-company index funds. "There's this pervasive belief that the small-cap market is inefficient," he says.

The data, though, sides with index funds. One study shows that even among small-company growth stocks -- a slice of the market thought to be ripe for active managers -- index funds still prevail. The study found that the benchmark beat most actively managed funds in seven out of the 12 five-year periods from 1997 through 2008. While our table shows that most actively run small-company funds beat the index over the past 15 years, those numbers don't take into account all the funds- -- often those with terrible records -- that have gone out of business.

Dash won't even concede that active managers fare better in funds that focus on small foreign companies and, especially, those that concentrate on emerging-markets stocks. This is an odd stance. You would think that hands-on managers would have a big advantage because stocks in these areas tend to fly under the radar of most investors and may be inefficiently priced. But the evidence is inconclusive. In emerging markets, actively run funds have prevailed over the past five years, but many have trailed the benchmark over the past ten. In this category, our instinct is to favor actively managed, low-fee funds until the data shows irrefutably that indexing is the way to go.