Tim Middleton

Mutual Funds3/6/2007 12:00 AM ET

Just beating the market is too easy

Why? Because index funds settle for the average, and the investing world is full of people and funds that are above average. Here are a few that can help you do better.

By Tim Middleton

Jack Bogle founded Vanguard Group on one simple premise: Indexing beats active management because indexes are less fallible than human managers.

So how come this year everything -- small funds, large funds, gold funds, technology funds, energy funds, health-care funds and even utility funds -- is beating the S&P 500 Index ($INX)?

It's a simple misunderstanding but one with profound implications for your personal fortune, and fortunes. "The market," as represented by the 500, isn't the market at all. It's the equivalent of an average domestic mutual fund that invests in large companies.

With the 500 down 0.51% as of Feb. 28, as represented by Bogle's flagship fund, Vanguard 500 Index (VFINX), you would have to work hard to do worse. And this isn't a fluke, although the breadth and depth of defeat is particularly stark right now.

If you've been tricked into thinking an S&P 500 index fund is a one-stop solution to your portfolio planning, it's understandable. Thanks to relentless promotion from Standard & Poor's and Vanguard, the 500, in the minds of investors, "represents the market," says Don Phillips, managing director of Morningstar. "It says, 'This is what stocks are doing.' "

The real market, however, has lifted the 500's skirt to reveal some pretty spindly legs. An easy-to-beat index isn't just S&P's problem, either. Phillips notes that Morgan Stanley Capital International's EAFE foreign-stock index was trounced throughout the 1990s by active managers, who simply avoided Japan, which represented as much as a third of that benchmark's weight.

If your life's goal is a gentleman's C, indexing was invented for you. But if you think you're as smart as Lisa Simpson, who gets A's, you'll find it takes very little homework to earn them.

In the first two months of 2007, however, even Bart Simpson made the 500 look like a dunce. Here are the average results of mutual funds in various categories, compared with Vanguard 500.

Average mutual fund performance
S&P 500LargeCompanyU.S.GoldLargeforeign Tech Health care EnergySmall Co.U.S. Mid-sizeCo.U.S. Realestate

- 0.51

- 0.06

0.65

0.71

0.97

1.04

1.19

1.59

2.93

5.30

Note: As of Feb. 28, 2007, close
Source: Morningstar

A two-month snapshot is hardly damning evidence of anything. Also, as a spokesman for S&P points out, comparing foreign stocks and domestic small ones with the 500 is "not an apples-to-apples comparison."

But over longer periods, indexes do not compare favorably with above-average mutual funds, and they are shamed by really good ones. Here are examples:

Indexes vs. their rivals
 Performance

YTD

1 year

3 years

5 years

Vanguard 500 (VFINX)

- 0.51

11.80

8.95

6.69

Average large cap

- 0.06

10.75

8.91

6.68

Sentinel Common Stock (SENCX)

- 0.64

12.58

9.76

7.90

Janus Contrarian (JSVAX)

4.69

22.80

21.43

17.50

S&P Mid-Cap Index (IJH, news, msgs)

4.64

9.56

12.93

11.89

Average midcap

2.93

11.94

12.28

11.62

Van Kampen American Value (MSAVX)

1.77

16.97

14.53

12.50

Kinetics Paradigm (WWNPX)

1.09

18.48

21.34

20.09

S&P Small Cap Index (IJR, news, msgs)

1.35

8.32

13.56

12.88

Average small cap

1.59

8.92

12.23

12.51

Quaker Small Cap Value (QUSVX)

1.11

9.82

13.67

14.45

Pacific Advisors Small Cap A (PASMX)

2.66

22.03

23.50

22.34

iShares MSCI EAFE Index (EFA, news, msgs)

1.31

21.35

18.43

16.34

Average large foreign

0.71

18.53

17.74

14.30

Munder International Equity Y (MUIYX)

1.40

23.23

18.93

16.21

Gartmore International Growth A (GIGAX)

1.65

25.51

24.46

18.45

Notes: As Feb. 28, 2007, close. Rankings for Morningstar "blend" categories as of Jan. 31, 2007.
Source: Morningstar

Over five years, an investment of $10,000 in Vanguard 500 grew to $13,826. In Janus Contrarian (JSVAX), it ballooned to $22,407. Would you prefer $17,552 from S&P Mid-Cap Index (IJH, news, msgs) or $24,989 from Kinetics Paradigm (WWNPX)? How about, in the comparison most favorable to indexing, $21,322 from iShares MSCI EAFE Index (EFA, news, msgs) versus $22,328 from Gartmore International Growth A (GIGAX)?

It is true that over long periods, popular indexes and group averages converge. That's not surprising: Most fund managers' pay is linked directly to a benchmark. If their clients include pension funds and insurance companies, which value conventional investment wisdom above everything, they can be fired for doing too well.

But we individual investors are free to seek out quality managers, just as we seek out quality in other aspects of our lives. Select the actor most likely to draw you into a movie theater: Craig T. Nelson, William H. Macy or Tom Hanks.

And, of course, Nelson and Macy are way above average. The Vanguard 500 of acting is Henry Winkler. (Look him up in Wikipedia under the Fonz; that's how I found his name.)

Fans of indexing, and they are legion, will assert that, theoretically, Nelsons and Macys, let alone Hankses, can't sustain excellence over a career. That's why I don't go to the movies with these folks.

There are bunches of people who have beaten the indexes over the long term, from Warren Buffett and Bill Miller to Bill Gross and Bob Rodriguez. It isn't that hard to be above average: All the children in Lake Wobegon are.

At the time of publication, Tim Middleton didn't own any securities mentioned in this article.

Rate this Article

Click on one of the stars below to rate this article from 1 (lowest) to 5 (highest). LowHigh