Why I Would Avoid Index Funds

In a typical year, at least two-thirds of actively managed funds fail to beat index funds that fish in the same waters. One reason is that index funds cost a lot less to operate than actively managed funds do. Another is that many managers aren't especially good at their job. But I see good reasons to favor actively managed funds over the next year or two.

First, there's the matter of taxes, which are a headache for actively managed stock funds. Every year, funds are required to distribute to shareholders essentially all realized capital gains, net of capital losses. Index funds pay out little or nothing in taxable capital gains to investors until you sell the fund -- because, in merely tracking an index, they make few stock trades. Exchange-traded funds, which almost always seek to match an index, are even more tax-friendly.

The one good side effect of the fierce 2007-09 bear market is that most funds now boast enormous capital-loss carry-forwards. These are capital losses that funds can employ in the future to offset gains from selling stocks that have appreciated. The upshot: You likely won't owe any capital-gains taxes on an actively managed fund for many years to come -- unless you sell the fund.

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The bear market wreaked indiscriminate havoc, and a lot of stocks fell much more than they should have. Declines in the share prices of many great companies, such as Johnson & Johnson (symbol JNJ), Microsoft (MSFT) and Procter & Gamble (PG), were right up there with the dregs. Why? Because hedge funds and other highly leveraged investors needed to raise cash quickly to meet brokerage margin calls as prices tumbled. They often sold shares of well-established companies because they could unload blue chips without moving their prices as dramatically as they would stocks of smaller companies.

Quality stocks now trade at little or no premium to the rest of the market. For example, the three companies mentioned above trade at less than 14 times their past 12 months' earnings. Fund managers can find plenty of growing companies with durable franchises and little debt selling at low prices relative to earnings, sales and other measures.

What's more, in the current market really junky stocks have performed better than high-quality fare. Turner Investment Partners found that since the market bottomed on March 9, the best performers have been those that had fallen the most in price during the bear market, carried the highest ratios of price to book value (assets minus liabilities), were the most volatile and sported the lowest share prices.

All these factors generally presage lousy stock performance. Companies trading at high price-to-book-value ratios typically make poor investments. Stocks that bounce around in price a lot also may be suspect. Lousy companies often deserve to sell for single-digit share prices. Turner calls the rise of these junky stocks "an atypical, perverse phenomenon…. an investing anomaly."

This kind of stock-market behavior never lasts long. Indeed, Turner found that from May 9 through mid June, high-quality stocks outpaced junk stocks. I think that trend will continue for months or years to come-regardless of whether the market goes up, down or sideways.

I'm not alone. The editors of No-Load Fund Analyst, an investment newsletter, say many managers they've interviewed cite exceptional opportunities in stocks -- even if the economy continues to worsen. "We believe we are in the midst of a period in which the environment for stock picking may be much better than the overall outlook for the market," the newsletter concludes.

I wouldn't put much, if any, new money in most index funds just now. Rather than invest in a fund that tracks Standard & Poor's 500-stock index, I'd buy Vanguard Primecap Core (VPCCX), Selected American Shares (SLASX) or Fidelity Contrafund (FCNTX). Instead of a foreign index fund, I'd invest in Dodge & Cox International (DODFX). For stocks of small companies, consider T. Rowe Price Small-Cap Value (PRSVX) in place of a fund that tracks the Russell 2000 index or some other small-cap benchmark. (All of these funds are members of the Kiplinger 25.)

The market gods stack the odds against actively managed funds, with their higher expense ratios and tax disadvantages. I'd bet on the funds mentioned in the preceding paragraph over index funds in any kind of market. But in today's environment, I'm willing to lay odds that good actively managed funds will prevail over the next year or two.

Steven T. Goldberg (bio) is an investment adviser.

Steve has been writing for Kiplinger's for more than 25 years. As an associate editor and then senior associate editor, he covered mutual funds for Kiplinger's Personal Finance magazine from 1994-2006. He also authored a book, But Which Mutual Funds? In 2006 he joined with Jerry Tweddell, one of his best sources on investing, to form Tweddell Goldberg Investment Management to manage money for individual investors. Steve continues to write a regular column for Kiplinger.com and enjoys hearing investing questions from readers. You can contact Steve at 301.650.6567 or sgoldberg@kiplinger.com.