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The Case for Index Funds

Despite the recent rough stretch, they're the way to go for the majority of investors.

The surest advice an investing Web site can give the majority of its readers can be reduced to three words: Buy index funds.

Of course, that's not entirely practical in a world where most people shoot to beat the market (it also leaves a lot of room on the page). But even that sound advice has come under fire recently, as the most popular index fund, the

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Vanguard 500, which uses the

S&P 500

as its benchmark, has lost 38.59% since March 30, 2000.

Today's column offers several reasons why investors are well-served using index funds in their portfolios. But I should start with a clarification: Indexing is not the S&P 500 alone.

"We're constantly being asked questions presupposing that the S&P 500 and indexing are synonymous," said Will McClatchy, co-founder of

Indexfunds.com and author of

Index Funds: Strategies for Investing Success

. "It's astounding that so many people make this mistake; indexing is using a low-cost, benchmark-pegged approach to investing in a variety of asset classes."

Better Than Average

In Lake Wobegon, all the children are above average. Lake Wobegon, of course, is a fictitious place -- and so is a stock market in which many, let alone all, can be above average.

"Half of the investors will outperform the market. That means the other half will underperform," says Gus Sauter, chief investment officer at Vanguard and manager of Vanguard 500 and

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Vanguard Total Stock Market Index.

That outperformance is in a given year -- it doesn't necessarily mean the same fund managers will outperform over the next one, five, 10 or 20 years. "Beating the market for one year -- even for 10 years -- has no predictive power over whether that individual will outperform in the future," said Larry Swedroe, a financial planner and author of

Rational Investing in Irrational Times

.

The Vanguard 500 fund has outperformed 81% of its large-cap peers over the past 10 years, according to Morningstar.

Let's look at how the investor in the average mutual fund has performed in comparison with an index fund that tracks the S&P 500, courtesy of indexing devotee Burton Malkiel in the newest edition of his

A Random Walk Down Wall Street

. According to Malkiel, an investor who put $10,000 in an S&P 500 index fund in 1969 would have a portfolio worth $327,000 by the end of 2002, assuming dividends were reinvested. A second investor who put $10,000 in the average actively managed mutual fund would have a portfolio worth $213,000. The index fund investor had a 50% greater return than the average. (For more on Malkiel's thoughts,

read this interview.)

"I think investors should recognize that the odds are stacked against actively managed funds," said Sauter. "The majority will underperform."

It's Cheaper

The greatest selling point for index funds -- and a key reason for the long-term outperformance -- is the price. The average U.S. stock fund carries an expense ratio of 1.51%; the average Vanguard fund, by comparison, carries a 0.27% expense ratio.

This example, by Thomas D.D. Graff and James M. Dugan of Cavanaugh Capital Management, drives home how much price matters. Investor No. 1 invests $100,000 in a portfolio of index funds, with an expense ratio of 0.22%. The portfolio returns 10% a year over 10 years. Investor No. 2 investors the same money in actively managed funds, with an expense ratio of 1.53%. The portfolio also returns 10% a year over 10 years. After 10 years, Investor No. 1 has $253,724, Investor No. 2 has $222,314. The difference: $31,410, or 14%. And that's assuming Investor No. 2 finds actively managed funds that keep up with the markets.

Another major cost benefit of index funds comes on the tax side of the equation -- something few investors pay any heed. A recent Lipper study found investors give up as much as 23% of their total returns every year because of mutual funds that don't try to minimize taxes. Index funds are among the most tax-efficient funds available. (Check out

this story for a fuller explanation for how tax-efficient funds benefit your portfolio.)

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A Coin Toss

Index fund adherents like to compare fund managing to coin flipping. In

A Random Walk Down Wall Street

, Malkiel discusses a coin-flipping contest in which 1,000 contestants try to continually flip heads. As chance dictates, 500 would flip heads in the first round and would be allowed to advance to the next. In the second round, only 250 head-flippers advance. According to the laws of chance, by round seven, only eight of 1,000 have flipped heads.

This analogy is meant to show that the laws of chance can explain some amazing success stories.

What about the Bill Millers of the mutual fund world? The

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Legg Mason Value Trust manager has beaten the market in each of the past 12 years -- an astonishing feat. Of course, Miller and other fund managers have managed to outpace the market over the long haul. There are investing geniuses out there who can beat the market. But it's tough to know them in advance, and it's still tough to know them after 10 years. Consider the case of David Baker.

David Baker managed the 44 Wall Street fund, one of the hottest funds of the 1970s, racking up 36% a year on average over the decade. Predictably, the money poured into the fund. From 1980 to March 1988, Baker's fund lost 22% a year on average, and Baker left the fund.

Style Drift Protection

One of the keys to a diversified portfolio is style purity. In other words, if you are investing in a small-cap value fund, you don't want the manager pouring your money into large-cap growth stocks. "Style drift," in which a manager moves outside of the fund's asset class, can wreak havoc on a portfolio's balance.

But beyond asset allocation, style drift also may have an effect on a fund's returns. Recent studies, including a 2001 study by Keith Brown and W.V. Harlow, have found that funds that are consistent in their investment style produce better returns that those with style drift. Style-consistent funds also have lower portfolio turnover, which means lower costs.

Index funds, by definition, remain consistent in their style.

Follow the Leaders

"Why is it that at least two to three times as many institutional investors index compared with individual investors? The smart money is clearly indexing," said Will McClatchy, author of

Index Funds: Strategies for Investing Success

.

Indeed, many institutional investors, such as pension plans, opt for index funds because of the long-term returns and low costs. (Although it should be noted that total indexed assets declined by 8% during the first half of 2002.) If big pension plans concede that they aren't confident enough picking winners, perhaps individuals might do well to follow suit.

One of the smartest of the smart-money set -- the man who tutored Warren Buffett -- also gave an endorsement for index funds late in his life. Shortly before Benjamin Graham died in 1976, he was quoted in an interview in the

Financial Analysts Journal

as saying: "I am no longer an advocate of elaborate techniques of security analysis in order to find superior value opportunities. This was a rewarding activity, say, 40 years ago, when Graham and Dodd was first published. I doubt whether such extensive efforts will generate sufficiently superior selections to justify their costs."

Core and Explore*

Many index-fund followers suggest using index funds exclusively to achieve a diversified portfolio. Indexfunds.com has a

great editors' picks section recommending index funds for all asset classes.

Even for investors (like me) who believe in judicious use of actively managed funds, broad-based index funds such as the Vanguard Total Stock Market Index fund can be a great choice for the "core and explore"* portfolio.

Core-and-explore portfolios use index funds as the core of the investment to get broad market representation and diversification at a low cost. Then, they "explore" by venturing into actively managed funds -- maybe a sector fund or emerging-market fund -- that they hope to use to beat the market.

Like every other investment strategy, it still proves tough to beat the market with core-and-explore -- but it may be cheaper and more successful than going with actively managed funds only. (For more on core-and-explore portfolios, check out this

TheStreet.com oldie but goodie.

Get a Life

It's not the 1990s anymore, back when everyone got 25% annual returns no matter what they did. Investing isn't all that fun to most individuals. People don't check their portfolio on Yahoo! every day -- heck, some don't even open up their quarterly statements. Sadly, I have a hunch the markets won't be that much fun over the next decade either.

The point: Index funds offer the easiest way for individuals to have a diversified portfolio that only requires close inspections about once a year for rebalancing purposes. That way, you have more time to do other things.

"You don't have to do all this research on managers, and you 'settle' for average market returns," says John Spence, associate editor at Indexfunds.com. Given that annual returns run at about 7% over the long run, you could do worse -- and many active fund investors do.

* TheStreet.com has been informed that the term "Core & Explore" was coined by and is a registered trademark of Charles Schwab & Co., Inc.