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 thesmall-cap market, a topic that this column
addressed last week. But index funds coveringbroad swaths of the market do serve a purpose and, as a result, have afollowing.
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 theirequity portfolios?" writes reader Armando Basarrate. "I believe the answeris self-evident."
Indeed, the last 10 years have provided compelling evidence in favor ofindexing. During the bull market of the 1990s, most large-cap fund managerscouldn't beat the
. But they insisted that this would change once the market turned ugly because they could load up on cash and move to saferstocks.
That theory might have been true in 2000. The S&P 500 beat only 41% ofactively managed large-cap funds that year. But in 2001, the S&P 500 onceagain 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 theindex over time, let alone beat it," writes David Ladd, who runs his ownmoney management firm.
No Middle Ground
So index investing seems to work better in the large-cap market, whilestock pickers do well when competing against a small-cap index like theRussell 2000. But "what about mid-cap index funds?" asks reader BrandonSklar.
You probably don't need to segment the market that much. Simplicity isone 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 bydividing your portfolio into numerous asset classes.
The idea is to build a portfolio of investments that won't all move inthe same direction at the same time. You can do that with large-cap andsmall-cap funds. "You only use a mid-cap index fund if you're an asset-classjunkie," says William Bernstein, a principal with Efficient Frontier Advisors.
If you own the S&P 500, you can expand your exposure with a small-capfund. (Ian McDonald recently did a screen of
small-cap growth funds.) If you just have to buy anindex fund, you'll get both mid- and small-cap stocks with a fund that tracksthe 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 tracksthe Wilshire 5000 index, which represents the entire U.S. market.
But none of these choices will insulate you from a plunging market. Evena 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 greatinvestment tools, but it should convince you to put some of your money inbonds 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 fiveasset classes when designing model portfolios for investors: large-cap,small-cap, international, bonds and cash. And you can fill in all of thesecategories with index funds.
Reader Ed Harrison is facing this very situation. "I have very limitedfreedom 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, outlookand stress level.
Schwab's Web site includes a great diversification tool that willlead 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 todiversify your portfolio among various asset classes -- not if you should buyan index fund. But index funds are a simple way to tap into those assetclasses. Don't let the market's poor performance during the past two yearssteer you away from this useful investment tool.
In keeping with TSC's editorial policy, Dagen McDowell doesn't own or short individual stocks, nor does she invest in hedge funds or other private investment partnerships. Dagen welcomes your questions and comments, and invites you to send them to