Investors Shouldn't Overlook Index Funds

Most of us simply don't have the time to spend hours a day studying market fluctuations, analyzing economic data or researching a company's growth forecast to decide where to invest our hard-earned money.

Our first thought may be to pay professional money managers and stock brokers to do the work for us. But what if there was a way to beat the professionals and save money in the process?

Well, there is and they're called Index Funds.

They're called that because their job is to match the performance of a particular index such as Standard & Poor's Index of 500 stocks. Some people call this "passive" investing because you don't really have to do anything. "Active" investing is where you "actively" buy and sell individual stocks hoping to out-perform the market.

There is an ongoing debate within the investment community between fans of "passive" and "active" styles of investing, and it's true that each has its good points and its bad points.

For example, active fund managers will argue that they offer value-added guidance during periods of market volatility while passive investors are forced to take the hits when their index drops. On the other hand, passive investors point out that index funds have actually outperformed many actively managed funds over time, so why pay more for a high-priced active fund manager to beat the market when most of them don't?

A recent Standard & Poor's "Index vs. Actively Managed Funds Score Card," showed the S&P index funds outperformed 80% of actively managed large cap funds for the first three quarters of 2006, and outperformed more than 75% of all actively managed funds for the past five years.

In 2006, 76 percent of active funds investing in large U.S. companies failed to beat a large-company stock index benchmark, according to data from Morningstar, the mutual fund ratings service. Meanwhile 94 percent of actively managed large value funds, which try to pick undervalued stocks, failed to beat the value index.

Why, you may ask, does this happen?

Efficient Markets

It just doesn't seem logical that actively managed funds wouldn't do better than the passively managed index funds. After all, the main reason you agreed to pay a fund manager was so your money would grow faster, right?

Well, one answer involves a tricky concept called the "efficient market theory" which in effect claims that the stock prices in a particular market already reflect everything there is to know about the companies those stocks represent.

What does this mean?

It means you really can't outsmart or outperform such an efficient market since that market and the stocks in it are performing just the way they're supposed to. Now you have to ask yourself -- why pay someone to even try? Aren't you better off buying a lower cost index fund that tracks the entire market?

That leads us to the second factor impeding the performance of actively managed funds -- expenses.

Expenses are a lot higher for actively managed funds than for index funds for a number of reasons. They have to pay for management fees, for research and transaction costs, and for taxes. By contrast, the average cost of an index fund is about half that of an actively managed fund.

According to Morningstar, the cost of the average index fund is just 0.80%, while the cost of the average actively managed mutual fund is 1.56%.

As index funds become more popular, financial services firms like Citigroup and A.G. Edwards are offering, for a fee of course, to help investors build diversified portfolios of index funds. Some will only accept accounts with minimum investments of $25,000 or more, and then charge 1% of assets for their help.

Alternative Indexes

Recently, a new trend among index-fund investors has developed. They have begun to take on more risk by passing up the more traditional index funds such as S&P 500, for what are called "alternative" index funds. You need to be careful here because some of them charge higher fees, track the markets in different ways and tend to be less than a year old so they don't have a track record.

Financial experts warn that alternative index funds lack many of the benefits of traditional index funds because they track narrow, volatile market segments, such as commodities and currencies. Some even use complex financial products such as derivatives, or borrowed money.

Still, there are plenty of reasons to buy traditional, broad-based index funds.

• First is quality. They outperform most actively managed funds.

• Second is price. Index funds are cheaper than actively managed funds because you don't have to pay a fund manager, and they don't buy and sell stocks as frequently as managed funds, so transaction costs and tax consequences are much lower.

• Third, index funds have a built-in protection stability mechanism to shield you from unscrupulous securities pickers who may for whatever reason change their investment strategies and start investing in securities you might not want to own.

Investing in mutual funds can be a daunting task, but you can simplify the process considerably by looking at low-cost index funds and save time and money in the process.