Index Funds Aren't Always the Best Choice - TheStreet

NEW YORK (TheStreet) - Investors have been pouring into index funds since actively managed portfolios lagged benchmarks in 2008.

Of the $7.4 trillion in long-term funds, 20% is in passive portfolios. That's up from 11% in 2000, according to

Morningstar

(MORN) - Get Report

.

Should you index all your assets? Probably not. While index funds can be sound choices, they are not always the best options. In some instances, active funds can provide lower risk and bigger returns.

Consider the

Vanguard 500 Index Fund

(VFINX) - Get Report

, the oldest S&P 500 fund, which has declined 0.6% annually during the past 10 years and lagged 56% of large blend funds. Investors would have been better off owning the

Franklin Rising Dividend Fund

(FRDPX) - Get Report

, an active large blend fund that returned 6.5% annually during the decade.

Franklin follows a cautious approach, buying blue chips that have increased their dividends in at least eight of the past 10 years. Holdings include steady performers such as

Wal-Mart Stores

(WMT) - Get Report

and spice maker

McCormick

(MKC) - Get Report

.

Proponents of index funds may argue that there is no way to know whether the Franklin portfolio will continue outdoing the benchmark. That's fair enough. But the Franklin fund does offer lower risk based on its standard deviation, the amount an investment bounces.

Franklin Rising Dividend consistently reports low standard deviation and outdoes the S&P 500 during downturns. Is Franklin likely to be less risky in the next decade? Yes. Many studies have shown that funds with low standard deviations in the past tend to maintain it in the future.

In a bull market, Franklin could easily lag the S&P 500. Still, the active fund should appeal to cautious investors who want to build a portfolio that can survive rough markets.

For foreign exposure, some investors use index funds that track the

Morgan Stanley Capital International EAFE Index

. A solid choice is the

Dreyfus International Stock Index Fund

(DIISX) - Get Report

, which returned 0.2% annually during the past decade. But many investors should consider the

Federated International Leaders Fund

(FGFAX) - Get Report

, an active fund that returned 8% annually during the past decade.

Dreyfus lagged Federated partly because of asset allocation. As an index fund, Dreyfus must follow the benchmark's weightings, always keeping about 20% of its assets in Japan, a country that has trailed global markets. The benchmark also lacks holdings in the top-performing emerging markets of Latin America.

As an actively managed fund, Federated is free to adjust weightings. Recently the fund had 1% of assets in Japan and 5% in Latin America. An active fund can avoid troubled regions and emphasize areas of high growth.

To invest in the emerging markets, a popular choice has been the

iShares MSCI Emerging Markets Index

(EEM) - Get Report

exchange traded fund, which has returned 12% annually during the past five years, outpacing 50% of emerging markets funds. But many investors may prefer the

Oppenheimer Developing Markets

(ODMAX) - Get Report

, an active fund that returned 16%.

The ETF trailed Oppenheimer partly because the benchmark emphasizes the most developed countries in its investment strategy. The largest iShares holding is

Samsung Electronics

, the Korean electronics giant, and 31% of assets are in Korea, Taiwan and South Africa. These countries may make sound investments, but they aren't the fastest growing in the world.

In contrast, the top three countries represented in the active Oppenheimer fund are India, Brazil and Mexico, which together account for 35% of assets. Oppenheimer's biggest holding is

Infosys Technologies

(INFY) - Get Report

, an Indian outsourcing company.

To own high-yield bonds, index investors can use the

SPDR Barclays Capital High Yield Bond ETF

(JNK) - Get Report

, but many investors should pick the

Vanguard High Yield Corporate Bond Fund

(VWEHX) - Get Report

, an actively managed fund. The Vanguard fund charges an expense ratio of only 0.32%, compared to 0.40% for SPDR. Vanguard also invests in higher-quality bonds. The portfolio has an average credit quality of BB, one step below investment grade. SPDR's portfolio has the next lower rating of B.

Higher-quality bonds are less likely to default and should hold up better in market downturns. This occurred in 2008, when Vanguard outperformed, losing 21% while SPDR lost 24%. When low-quality bonds led the rally in 2009, Vanguard still produced better returns, gaining 39%, compared to a return of 38% for SPDR.

The explanation for Vanguard's outperformance could be connected to the way bond benchmarks are structured. In the index, companies with more debt outstanding carry more weight. So if a company issues more debt, an index fund must buy it.

Vanguard's managers are free to stay away from heavily indebted companies. That may help the active fund to outperform.

-- Reported by Stan Luxenberg in New York

.

Stan Luxenberg is a freelance writer who specializes in mutual funds and investing. He was formerly executive editor of Individual Investor magazine.