The Smart Way to Use Index Funds Now

When the bull market was hot, so were index funds. The Vanguard 500 Index Fund even eclipsed Magellan as the largest mutual fund in the country, and other index funds dominated their actively managed peers as well.

Nevertheless, nearly three years of a bear market have pushed some indices back to pre-boom levels and cooled investor enthusiasm for index funds in general. Indeed, over the past 12 months, says Morningstar, 53 percent of actively managed mutual funds outperformed the indices. That may not be spectacular performance by active managers, but it's better than in 1998, when index funds beat 80 percent of their actively managed peers.

Suddenly, index funds aren't the no-brainer everyone thought they were. In the cold light of the bear market, advisors have discovered inherent flaws in the indices and the funds that track them. Take funds tied to the S&P 500, for example. In the '90s, they were very popular — an easy way for clients to hitch a ride on the rising bull market.

But because the S&P 500 is weighted by market capitalization, fluctuations in the share price of big companies can cause wild gyrations. At the height of the bull market, the top S&P 500 members — including Microsoft, General Electric and Intel — accounted for more than 20 percent of the index. The top 50 stocks accounted for more than 55 percent. When those names collapsed, so did the S&P.

Still, that's no reason to abandon index funds. Just make sure you know why you're purchasing shares of an S&P 500 tracker: It is an effective tool for owning a limited group of mainly large-cap growth issues. The S&P index is a core holding when it is surrounded by other investments — then, you have built a diversified portfolio.

“I use actively managed funds when I can find one that will consistently outperform the index with less risk,” says Jeff Bright, president of Bright Financial Advisors in Kalamazoo, Mich. “Otherwise, I will look for an index fund.”

Bright likes the low fees of S&P funds, but he worries that the market weighting system reduces diversification. To compensate, he mixes funds. In recent portfolios he has designed for clients, Bright included an S&P 500 mutual fund along with Diamonds, an exchange traded fund that tracks the Dow Jones Industrial Average.

The Dow leans toward value stocks, balancing the S&P's tilt toward growth issues. In addition, Diamonds avoids some of the hazards of market-weighted benchmarks because the Dow is price-weighted. Under this system, a Dow stock that costs $50 a share counts for about twice as much as a stock priced at $25 regardless of market capitalization. With price weighting, it is unlikely that two or three hot stocks can dominate the index.

Lack of diversification can also be an issue for investors in Nasdaq 100 Trust shares (nicknamed “Cubes” for its ticker, QQQ), the popular exchange traded fund that is used as a technology sector tracker. Even now, the three biggest holdings in Cubes — Microsoft, Intel and Cisco Systems — account for more than 20 percent of the fund's assets. That concentration helps explain why Cubes has lost more than 25 percent annually during the past three years.

Investors seeking a less volatile tech index fund might consider North Track PSE Technology 100 A, which has outpaced Cubes by more than 15 percentage points annually for the past three years. North Track's success can be traced to its benchmark: 100 leading stocks of the Pacific Stock Exchange index. These are price weighted so no issue accounts for more than 4 percent of the index. And, the Pacific Stock Exchange only puts profitable companies in its benchmark, which protected shareholders from Internet disasters.

Some funds appear adequately diversified and low-cost, and yet they still fail to produce competitive returns. Among the notable disappointments is Vanguard Small Cap Index, which has lost more than 18 percent annually during the past two years, 16 percentage points behind the average small blend mutual fund.

Vanguard's weak returns are due to its benchmark, the Russell 2000. Frank Russell Co. structures the index by putting the 1,000 largest stocks in the Russell 1000 and then adds the next 1,000 to create the Russell 2000 small cap index. Once a year, the Russell 2000 is rebalanced. In recent years, up to 30 percent of the stocks in the index have been eliminated each year because they no longer meet size requirements. This process has punished Russell index funds in a variety of ways.

In 2000 and 2001, highflying tech stocks joined the Russell 2000 — just before many of them collapsed. In some cases large stocks dropped from the Russell 1000 into the Russell 2000 on their way to oblivion. Critics complain that strong companies quickly outgrow the Russell 2000, leaving the index loaded with former large caps that have fallen on hard times. And the constant churning of the names in the index creates capital gains for funds and makes them tax inefficient.

Advisors say a better choice for small cap indexers may be Dreyfus Small Cap Stock Index or some other fund that tracks the S&P 600. This index has relatively strong companies and little turnover. That's because members of the index are picked by an S&P committee that only considers profitable stocks with sustainable earnings.

The names in the index are changed gradually throughout the year, limiting the amount of taxable gains that funds record. Even Vanguard recognizes the superior tax efficiency of the S&P 600; Vanguard Tax Managed Small Cap fund tracks the index. “Vanguard should stop allowing new money into its Russell 2000 index fund and open a fund that tracks the S&P 600 [instead of watering down the index with a tax-efficient strategy],” says Larry Swedroe, a principal with Buckingham Asset Management, in St. Louis.

Even when index funds deliver adequate long-term returns, advisors need to study how benchmarks are constructed. In some cases, index funds simply don't act the way many investors would expect.

Consider the case of Vanguard Value Index, which tracks the S&P/Barra Value index, a large cap benchmark. During the past year, value funds have outpaced growth funds by more than 10 percentage points, yet Vanguard Value has lagged its sibling Vanguard Growth. This seeming anomaly occurred because S&P/Barra only determines membership in the benchmark according to one criterion: price-to-book ratios. Companies with below-average ratios are selected for the value index.

This has resulted in Vanguard Value holding some tech stocks — such as Sun Microsystems and EMC — that most active managers regard as growth stocks. “Many people who consider themselves to be diehard value investors will be disappointed with the Vanguard Value portfolio,” says William Harding, an analyst with Morningstar. He suggests most value investors will feel more comfortable with iShares Russell 1000 Value, an exchange traded fund that takes into consideration forecasted earnings as well as price-book ratios.

Sheldon Jacobs, editor of No-Load Fund Investor, says the ideal index fund would be passively managed and weigh each stock equally. Unfortunately, he says, no such broad-based fund exists, and investors must approach all index choices with caution. “All these are made up by people,” he says, “and none of them are perfect.”

Leaders and Laggards

Some index funds produce sound returns, while others have notable flaws. Here are examples of mutual funds and exchange traded funds, which trade like stocks, at both ends of the spectrum.