Now, picking a fund is like visiting Baskin-Robbins
Chicago, Jan.2, stock investing .- It’s a straightforward strategy: Track a broad swath of the market by buying shares in a low-cost index fund. But it’s hardly the new, new thing; the country’s first index mutual fund, Vanguard 500 Index, opened in 1976. Yet indexing has never been more popular, and the numbers of distinct benchmarks and the funds that track them have swelled. There are now 1,732 index portfolios, compared with 419 a decade ago. Meanwhile, assets in stock index funds have grown 70% over the past five years, to $2 trillion, and cash in bond index funds has more than doubled, to $510 billion. Over the same period, money invested in actively managed U.S. stock portfolios has shrunk by 18%.
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What's the attraction? Performance, of course. Index mutual funds and their brethren, exchange-traded funds, have done better than most actively managed funds over time. For example, Vanguard 500 Index (symbol VFINX), which mirrors Standard & Poor's 500-stock index, has outpaced 80% of all actively managed large-company, U.S.-oriented stock funds over the past three years.
Expense advantage
Index funds have other draws. Most important, they're cheap. Vanguard Total Stock Market Index (VTSMX), the largest index mutual fund, charges just 0.17% per year. The expense ratio for the ETF version of the fund, Vanguard Total Stock Market ETF (VTI), is a mere 0.06%. (ETFs are baskets of securities that trade on exchanges just like stocks.) By contrast, the average expense ratio for actively managed U.S. stock funds is 1.32%.
Another plus for index funds: When you buy one, you pretty much know what you're getting. The holdings in an index fund, which are clearly defined by the rules of the benchmark, are transparent. "Investors want more clarity about what they're investing in," says Matt Tucker, of iShares. (Actively managed mutual funds disclose portfolio holdings only once a quarter.) Combine all of that with a higher level of fear following the cataclysm of 2008 and you have skittish investors fueling an indexing boom.
But don't rush to brush off all actively managed funds. Although the typical active large-company U.S. stock fund lagged Vanguard Index 500 over the past one, three, five and ten years, "above average" funds fared better, according to a new Morningstar study. (Morningstar defined above-average funds as those with low fees and long manager tenure, among other things.) In fact, cheap actively run funds (defined as those with expense ratios in the bottom 25%) beat Vanguard 500 over the past ten, 15 and 20 years. The takeaway: "It is possible to find actively managed funds that outperform" their benchmarks, says Morningstar analyst Dan Culloton. "But you must have patience and discipline to stick by those funds over time."
Dodge & Cox Stock is a case in point. A member of the Kiplinger 25, it beat the S&P 500 for five consecutive calendar years in the early and mid '00s, and investors poured money into the fund. But Stock stumbled in 2007 and 2008, after which "people couldn't get out of it fast enough," says Culloton. The fund performed well in 2009 and 2012, however, and its ten- and 15-year returns now beat those of the S&P 500. Helping the fund deliver strong long-term results is an unusually low expense ratio (for an actively managed fund) of 0.52% annually.
We believe there's a place in every portfolio for passively managed index funds or ETFs (or both) and actively managed mutual funds. "It doesn't have to be either-or," says Culloton. It can make sense, he says, to use index products in asset classes, such as large-company U.S. stocks, that are considered more efficient. Hire active managers for the less-efficient pockets of the market, such as stocks of tiny companies, known as micro caps, and emerging markets.
That's how the folks at Kanaly Trust, a Texas financial adviser, manage their clients' money. They use index funds or ETFs except in certain asset classes, such as emerging markets or municipal bonds, in which they think an active manager can make a difference. Says chief investment officer James Shelton: "If we can find an actively managed fund that has outperformed over a long period of time, and that outperformance exceeds the higher fee we have to pay for it, then why wouldn't we invest in it?"
Another way to go is "core and explore," says Culloton. Build a core portfolio of index funds -- domestic stock, international stock, and bond index funds, for instance -- and complement it with funds that have managers who you think can beat the market. "The index funds control risk by ensuring that part of your portfolio is getting the market return minus costs. The active funds give you a shot at outperformance over the long term," Culloton says. Or round out your core portfolio with small bets in index funds that focus on riskier asset classes, such as an ETF that owns Japanese stocks or an index fund that specializes in biotech stocks.
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