Beat the market with a mix of index funds

By Forbes.com

It was a radical concept that Vanguard's founder, John Bogle, offered to the public in 1976 with the creation of the Index 500 fund (VFINX). He was going to sell you guaranteed mediocrity. This fund would passively track the Standard & Poor's index ($INX) of 500 large companies. Bogle would hire no high-priced stock pickers, and he would keep the fund's trading to the tiny level needed to accurately track the index.

The concept wasn't an easy sell, and Bogle's pet fund got off to a slow start. But eventually people realized that this passive, unimaginative portfolio was in fact beating the majority of actively managed stock funds. As a group, of course, the active managers could not beat the market because they pretty much were the market. And since they were spending lots of money trying to beat it, they would eventually fall behind. History has proved out this theory. Only one in three actively managed stock funds in operation since 1976 has beaten the Vanguard 500.

Hundreds of index funds

Index funds are now a giant business, with hundreds of funds vying for investors' attention. That's a vindication for Bogle, but a problem for the would-be passive investor. You can't be so passive anymore, buying an S&P 500 fund and putting the thing away in a strongbox for 25 years. Now there are choices to make. What index should you track, and who has the best vehicle for tracking? There are funds to track the 500, funds to track a broader market basket and funds to track narrower ones, such as S&P 500 "growth" stocks and S&P 500 "value" stocks. You can get index funds that omit social undesirables like tobacco companies, and you can get index funds that track overseas stocks. Vanguard itself has more than 20 index funds, including one that just owns real estate investment trusts, one that just reflects small-cap growth stocks and five that follow bond indexes.

This article (with the accompanying table below) will help you find the best index funds for your stock portfolio. It also describes a strategy, advocated by one personal finance professor, that offers the tantalizing prospect of beating the market with a mix of market-tracking index funds. As we do twice a year in our fund guides, we also rate all large stock funds with long-standing records, both active funds and passive ones, with a grading system that looks separately at performance in bull and bear markets.

A good strategy, used by many a large pension fund, is to blend active and passive stock portfolio management. Make one or more index funds the core holdings in your portfolio and plan on holding them through thick and thin, bull and bear markets, for many years. Then take another chunk of your stock market money and invest it actively, either seeking out fund managers with superior records or creating your own portfolio of stocks.

First question: Who are the legitimate purveyors?

Plenty of phonies abound, poisoning the concept by charging high expenses. If you are going to pay a lot of money for a stock fund, it should not be run with guaranteed mediocrity as its objective. You should have at least a shot at getting on board with the next Peter Lynch. By our reckoning, any domestic index fund running annual expenses more than 50 cents per $100 of assets is a perversion of the indexing concept.

Vanguard has traditionally set the standard for low-cost index funds, but Fidelity USAA and Schwab are all competitive, with annual costs close to Vanguard's; these are all, like Vanguard's, no-load funds. You also have the option of buying an exchange-traded fund like the Spider that keeps costs low, but note that going onto the exchange entails trading costs that erase some of its seeming 9-cent advantage.

Next question: What index to follow?

The S&P 500 is a collection of bigger companies, with market capitalizations ranging from $500 million to $300 billion. There's a bigger world out there -- thousands of small companies that don't make the cut on the S&P 500 selection committee.

You can index your way into it. Sixteen years after creating the Index 500 fund, Vanguard opened a Total Stock Market Index fund (VTSMX), designed to track the broad Wilshire 5000 index ($TMW.X). Fidelity and Wilshire also offer low-cost index funds with thousands of stocks.

This fund is the great equalizer

It's like the difference between the House and the Senate. Most index funds, notably the S&P 500, are weighted by market cap. But one index fund has a Senate-like approach to the S&P 500. Morgan Stanley Value-Added Market Equity (VADAX) puts equal amounts of money into each of the 500 stocks, whether that's Microsoft (MSFT, news, msgs) ($300 billion market capitalization) or American Greetings (AM, news, msgs) ($1 billion).

A trend? The 15-year-old Morgan fund has won converts to its egalitarian portfolio. Though that fund's assets under management have held steady at around $1 billion in recent years, Rydex is following Morgan's lead and starting an exchange-traded fund based on the same principle. Standard & Poor's has just introduced an equal-weighted S&P 500 to make copying it easier, so there may be more funds based on it soon.

The appeal of equal weighting: Supposedly it does well in a down market, when (sometimes) smaller stocks fare better than large. The knock on cap weighting is that it overemphasizes hot stocks. Even now just 42 stocks make up half the S&P 500.

But be careful here. It is not foreordained that equal weighting makes an index more conservative. What if the largest companies by capitalization were stodgy oils and banks, while the midcaps were mostly speculative tech companies? Then the Morgan Stanley fund would be riskier than the traditional S&P 500.

The Morgan Stanley product is extremely expensive for an index fund. And it is not as tax-efficient: It must be rebalanced regularly, thus generating more capital gains. Finally, remember that during the tech mania of the 1990s the Morgan fund trailed the cap-weighted S&P 500.

-- Emily Lambert

Odd indexes

The Standard & Poor's index selection jury has a mission to ensure that S&P 500 companies be leaders. If they aren't (like Rite-Aid in 2000), out they go. Sounds sort of cold and (appropriately) corporate. But some indexes have a touchy-feely aspect. The Domini Social Equity fund (DSEFX ) tracks 400 companies that are on the side of righteousness, as defined by certain agendas.

The Vanguard Pacific Stock Index (VPACX)) has Japan plus Morgan Stanley's Pacific Index (TGRAX) (Australia, Hong Kong, Singapore). Oddly, no Korea or Taiwan. Morgan Stanley still considers them "emerging markets." Vanguard's emerging markets fund includes Korea -- and submerging Argentina.

If you want the Dow, the TD Waterhouse Dow 30 (WDOWX) tracks the famous industrial average. But note that the quirky Dow is not cap-weighted or even equal-weighted. It's weighted by stock price. A stock split forces the index fund to rebalance.