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Making the Most of Index Funds

Dagen McDowell

Index funds have surely lost some fans over the past couple of years. They go down when the market does and they aren't necessarily a panacea for whatever ails your portfolio.

But they're still solid investments. Thankfully, plenty of investors know that.

Actual stock picking does tend to work better than indexing in the small-cap market, a topic that this column addressed last week. But index funds covering broad swaths of the market do serve a purpose and, as a result, have a following.

But a few of my readers still had some questions about which index funds work the best. Answering some of these queries will offer ways to use this investment tool to make the most of your money.

"If indexing does not work, why do most large institutional investors, like pension funds and insurance companies, index large percentages of their equity portfolios?" writes reader Armando Basarrate. "I believe the answer is self-evident."

Indeed, the last 10 years have provided compelling evidence in favor of indexing. During the bull market of the 1990s, most large-cap fund managers couldn't beat the S&P 500. But they insisted that this would change once the market turned ugly because they could load up on cash and move to safer stocks.

That theory might have been true in 2000. The S&P 500 beat only 41% of actively managed large-cap funds that year. But in 2001, the S&P 500 once again had the upper hand, outpacing 61% of those funds.

"The argument for active management has always been and will always be: You have the opportunity to BEAT the index, why simply settle for the index? The answer, unfortunately, is that extremely few managers even match the index over time, let alone beat it," writes David Ladd, who runs his own money management firm.

No Middle Ground

So index investing seems to work better in the large-cap market, while stock pickers do well when competing against a small-cap index like the Russell 2000. But "what about mid-cap index funds?" asks reader Brandon Sklar.

You probably don't need to segment the market that much. Simplicity is one of the main benefits of investing in index funds. With one or two funds, you're buying the entire market. There's no need to complicate matters by dividing your portfolio into numerous asset classes.

The idea is to build a portfolio of investments that won't all move in the same direction at the same time. You can do that with large-cap and small-cap funds. "You only use a mid-cap index fund if you're an asset-class junkie," says William Bernstein, a principal with Efficient Frontier Advisors.

If you own the S&P 500, you can expand your exposure with a small-cap fund. (Ian McDonald recently did a screen of small-cap growth funds.) If you just have to buy an index fund, you'll get both mid- and small-cap stocks with a fund that tracks the Wilshire 4500 index. Vanguard has one called the Extended Market Index fund.

You can skip these steps by buying a Total Stock Market fund that tracks the Wilshire 5000 index, which represents the entire U.S. market.

But none of these choices will insulate you from a plunging market. Even a simple and conservative index fund can drop like a rock. Simply put, stocks go down and so will these funds. That shouldn't scare you away from these great investment tools, but it should convince you to put some of your money in bonds and cash.

Mix It Up

Luckily, diversifying your portfolio doesn't need to get complicated. Charles Schwab's Center for Investment Research, for example, uses only five asset classes when designing model portfolios for investors: large-cap, small-cap, international, bonds and cash. And you can fill in all of these categories with index funds.

Reader Ed Harrison is facing this very situation. "I have very limited freedom in my 401(k) plan. I have a bond index fund, an S&P 500 index fund, an international index, a small-cap index and a government short-term paper fund," he writes.

Harrison must figure out the mix of funds that fits his needs, outlook and stress level. Schwab's Web site includes a great diversification tool that will lead you to one of five asset allocations -- from conservative to aggressive. The site also includes the returns for these model portfolios over a 30-year period.

This is the most important decision you'll make when investing: how to diversify your portfolio among various asset classes -- not if you should buy an index fund. But index funds are a simple way to tap into those asset classes. Don't let the market's poor performance during the past two years steer you away from this useful investment tool.