By Charles Wallace,
NEW YORK ( DailyFinance) -- By now, most small investors know that investing in index funds is frequently superior to owning individual stocks or actively managed mutual funds. It turns out, however, there are several ways to squeeze even better returns out of your capital using unusually constructed index funds.
The art of investing is often a paradox. Choosing individual stocks is a game that requires a high degree of skill and knowledge, and most investors simply don't have the aptitude, nor the time to develop it. Even when they do, many buy and sell at the wrong times because of unconscious psychological biases.
Buying actively managed funds isn't much better. Research shows that 70% of actively managed mutual funds underperform stock indexes such as the S&P 500 over the long term. That's in part because they charge high management fees, typically 1.5% or more, while index funds, which invest in shares of the entire index such as the S&P or the Russell 1000, charge fees as low as .09%. Those differences really add up over time.
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Of course, it would be great if you could be sure you were picking an actively managed mutual fund from among the 30% that outperform the indexes. The problem is there is no easy way to choose one. Most funds list their results for the previous one-, five- and 10-year periods. But Joel Greenblatt, an adjunct professor at Columbia Business School, says that historical analysis shows that past results do not reliably predict winners over the next few years.This is why small investors have been encouraged to put their money in index funds rather than stocks or mutual funds. But Greenblatt argues in a short but compelling new book, The Big Secret for the Small Investor, that traditional index funds have drawbacks of their own. He says the returns can be improved dramatically by constructing index funds differently. Where Traditional Index Funds Go Wrong Most traditional index funds, like the iShares S&P 500 Index Fund (IVV) or the State Street SPDR S&P 500 ETF (SPY), own all the shares in the index they track. The index is then weighted by market capitalization, or the dollar value of all the shares in the company.