Investing in Index Funds

I guess not much has changed in the land of actively managed funds over the last several years. In 2006, former Investment U Chairman, Mark Skousen wrote, “80% of actively managed funds fail to beat the market.” Fast-forward to last year, and TIME Magazine reports, “Among large-cap fund managers, 79% trailed the return of the S&P 500.”

Yet this is only the beginning… In 2011, TIME adds, “57% of global funds, 65% of international funds, and 81% of emerging market funds trailed their benchmarks.”

You’d think investors would get tired of paying excessive fees for funds managed by experts who, more than half the time, don’t even beat the market they’re looking to in any given year.

Well, although the majority of investors still invest in actively managed funds today, it appears more and more are switching to passively managed index funds in the hopes of better returns.

Index Funds At a Glance

Index funds are simply investments that try to replicate the index of a specific market.

Unlike actively managed funds, index funds are passively managed. That means instead of having a fund manager choose which stocks are likely to head higher in any given index, an index fund would simply own all of the stocks in the index.

At the end of the year, this allows index funds to charge less in fees as opposed to actively managed funds. And it minimizes the taxes investors would incur had they gone with an actively managed fund.

There are two ways to invest in index funds, through a mutual fund or an ETF.

The Vanguard 500 Index Fund (Nasdaq:VFINX) is an example of an index mutual fund that seeks to track the performance of the S&P 500.

Vanguard 500 Index vs. S&P 500

Over the past five years, and as you’d hope, this fund’s chart looks strikingly similar to the S&P 500.

Yet, digging even deeper, traditional index funds like the Vanguard 500 Index may also have a major flaw…

They are cap weighted.

This means the companies with the biggest market caps in the indices they track make up the majority of the fund. Put simply, these funds invest in companies based on Wall Street “popularity,” not necessarily based on their fundamentals.

As Reuters recently reported, “Cap weighting tends to load up on the most expensive companies and shuns the big companies trading at deep discounts.”

So, what can you do?

The answer may lie in alternative index funds.

Alternative Index Funds

There are two alternative index funds to consider that can increase return with less volatility than their traditional cousin…

  • Equal-weighted index fund
  • Fundamental index fund

Equal-weighted index funds simply invest the same percentage into each of the stocks in it the index it’s tracking. An example of this is the Rydex S&P Equal Weight (NYSEArca:RSP), which was the first ETF to use equal weighting.

This index fund holds all the stocks that you’d see in a traditional S&P 500 index fund. But instead of making the S&P a “popularity contest,” it simply allocates 0.2% of the portfolio to each company in the S&P 500.

On the other hand, index funds weighted by their fundamentals, like the Powershares FTSE RAFI US 100 (NYSEArca:PRF), weights its index based on a company’s book value, free cash flow, revenue and dividends.

Both of these alternatives funds are technically passively managed, so they won’t cost as much as an actively managed ETF or mutual fund. But you’ll probably pay higher annual fees than simply investing in a traditional index fund. This is simply because fundamental and equal weight index funds require more maintenance throughout the year to maintain.

But at the end of the day, these alternative index funds also give you the opportunity to increase your returns with less volatility than a traditional index fund.

Good Investing,

by Mike Kapsch, Investment U Research

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