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Faith in Index Funds Rests on Flawed Research

Should you avoid index funds? Hardly. Low-cost index funds can be efficient. But it is important to keep in mind that all funds -- "whether index or active" -- have strengths and weaknesses. Russel Kinnel says he owns a mix of index and active funds. If you are a savvy investor who looks for low-cost funds, you can do well with either index or active funds, he says.

Many investors have been shifting to index funds lately for the wrong reasons, says Kinnel. He notes that in 2008 the S&P 500 lost 37%, and active funds performed about in line with the benchmark. Investors had reason to be disappointed with funds of all kinds, but much of the ire focused on active portfolio managers. "Investors thought that portfolio managers should have shifted to cash before the downturn," says Kinnel.

But the idea that managers can time the market perfectly is unrealistic, says Kinnel. Under SEC rules, most funds are not permitted to make massive swings to cash. Funds must live up to their names. So if a fund has the term "small-cap" in its name, it must keep 80% of the portfolio in the asset class. Such funds are bound to sink in market downturns.

Just as the exodus from active stock funds was motivated partly by irrational considerations, investors have also been making panicky moves with bond funds. While active stock managers about matched the benchmarks in 2008, active bond funds trailed badly. In 2008, the Barclays Capital Aggregate bond index gained 5.2%, and the average intermediate-term bond fund lost 3.7%. Even PIMCO Total Return (PTTAX), which is run by bond star Bill Gross, gained only 4.3% and trailed the benchmark by 0.9%.

You would think that angry shareholders should have dumped the PIMCO fund and shifted to index funds like Vanguard Total Bond Market Index (VBMFX), which returned 5.1% for the year. Instead, shareholders decided that Gross was a hero at a time when stocks had lost so much. Investors promptly poured tens of billions of dollars into active funds from PIMCO and other companies.

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