Index Funds

Why I Would Avoid Index Funds

Actively managed funds are poised to beat index funds over the next year or two.

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.

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.

Most Popular

Yes, You Can Collect Social Security from an Ex-Spouse: Here’s How
social security

Yes, You Can Collect Social Security from an Ex-Spouse: Here’s How

It’s always smart to maximize your Social Security benefits, and if you are divorced, one way to do that might be to take them based on your ex’s earn…
May 13, 2021
Refunds for $10,200 Unemployment Tax Break to Begin This Week
Coronavirus and Your Money

Refunds for $10,200 Unemployment Tax Break to Begin This Week

The IRS will start issuing automatic refunds in mid-May to people eligible for the unemployment benefit tax exemption.
May 14, 2021
18 Worst Things to Buy at Dollar Stores
spending

18 Worst Things to Buy at Dollar Stores

These discount retailers stock plenty of bargains, but some of the merchandise isn’t worth the buck.
May 14, 2021

Recommended

18 Dirt-Cheap Index Funds to Buy
ETFs

18 Dirt-Cheap Index Funds to Buy

Expense ratios for index funds have declined in recent years, making them an attractive low-cost investing strategy to consider.
April 23, 2021
American Century Small Cap Value (ASVIX) Joins Kip 25
Kip 25

American Century Small Cap Value (ASVIX) Joins Kip 25

American Century's small-cap-focused ASVIX consistently delivers high returns with average risk, and bears little resemblance to its benchmark.
April 30, 2021
The Disturbing Conflicts of Interest in Target Date Funds
mutual funds

The Disturbing Conflicts of Interest in Target Date Funds

Are you one of the 40 million folks who has a target date fund in your 401(k)? It could be costing you 21% in returns over the course of your career, …
April 30, 2021
The Kip 25: The Best Low-Fee Mutual Funds
mutual funds

The Kip 25: The Best Low-Fee Mutual Funds

The key to building wealth long-term is buying high-quality, low-cost mutual funds run by seasoned stock pickers. Here are our favorites: The Kiplinge…
April 29, 2021