Let’s dispel the notion once and for all that index funds are only for passive investors. Sure, the original index funds tracked the S&P and were meant for investors who either believed you couldn’t beat the market or didn’t want to try. Since their beginning, index funds have expanded their breath. You can find a fund which tracks any of the major indices and most industry sectors, such as health care and technology. The first cousin of index funds, Exchange Traded Funds (ETFs), do the same thing – they track indices. Between index funds and ETFs you can mirror any major index, small index, industry sector, industry sub-sector (i.e., biotech or software), global region or individual country. You can also try to outguess the indices if you want. For example, you can buy a S&P index fund which weights all 500 stocks equally or one which weights them by market cap, and so on. (Note to investors: make sure you know what you’re buying.) Thus far, we’ve only focused on equity funds but index and exchange traded funds also are available for fixed income securities. These funds are particularly suited for fixed income investments (Treasury, corporate or muni) because they can buy and sell bonds at much lower spreads than individual investors.

 

The proliferation of index and exchange traded funds means you can construct an entire portfolio of these funds to meet almost any investment strategy and risk level. A combination of a S&P fund, mid-cap and small cap domestic equity funds, foreign funds and fixed income funds of varying maturities, and a real estate fund would fit many investors objectives for a diversified portfolio with good growth potential and reasonable risk.

 

A mix of funds with individual securities or using a fund to fill a gap in your portfolio is an equally good idea. For the investor who wants to participate in, for example, biotech or emerging markets, a fund will enable her to achieve diversification in that sector (and the riskier the investment, the more important diversification becomes) with only a small investment.

 

Index funds can be bought and sold once a day; some ETFs as frequently as every hour. The larger funds are liquid investments and, in many cases, more liquid than their underlying securities (bonds and small cap stocks, for example). Transaction costs are modest, perhaps nothing for a no load fund (subject to certain holding period requirements) and typical stock commissions for an ETF.

 

So what’s the downside? There’s a body of academic literature and models which “prove”’ that a small group of fund mangers can outperform the market, think Peter Lynch and Bill Miller. If you believe this, and I do, or you just want to hedge your bet (I shudder as I write those words because investing is not a bet, it’s hard work and serious business), you can mix some actively managed funds in with your index funds and ETFs. The other issue you have to consider is that index funds/ETFs can take different investment strategies to for the same index. I gave the example above of two S&P 500 funds that are constructed differently. They will perform differently as a result. Structure and performance differences are even more pronounced as you invest in riskier/smaller indices. Taking biotech, for instance, one fund may broadly diversify, another may invest in the ten largest biotech companies, and a third may take a different investment approach. As a result, their performance will widely differ. So, again, make sure you understand your fund’s approach.  You can’t tell a book or a fund by its name.  Index funds and ETFs have a place in your portfolio; they’re no longer just for passive investors. 

 

A current theme among Wall Street wealth managers is for individual investors to have index funds as their core holdings and to focus the remainder of their assets in high alpha investments, which will produce returns not correlated with the market. 

 

A quick digression for those of you who aren’t familiar with alpha and beta. In traditional finance, the return not correlated with a broad market index, such as the S& P 500, is referred to as alpha. The return which is correlated to the market is beta.  An index fund should have the same return (positive or negative) as the index it mimics.  (One of the controversies surrounding some ETFs is their performance has not tracked their underlying index.)

 

The theory behind Alpha and Index Funds is multifold:  1. the major indices are a good place for an investor to be, both from a risk and return perspective;  2. you can’t outperform the major indices, so don’t waste your time;  3. find those investment niches with high alphas to increase your return and reduce the overall risk in your portfolio. Even if you don’t subscribe to this theory, you might find it an interesting exercise to review the alphas -- every investment has one -- of your current holdings. They will tell you something about the correlation and diversification of your portfolio.

 

Where to focus your alpha energy? Investments in real estate, commodities, and energy are less correlated with the stock market (although I’ve never thought commodities were suitable for individual investors).  The Wall Street pros also recommend stock fund mangers who have unique strategies and can demonstrate a high alpha relative to the market (and, of course, positive relative performance). Ask your investment advisor for suggestions.  The alphas for individual mutual funds (and individual stocks) are available from some brokers and online premium services. 

 

Alpha and index fund investing makes a great deal of sense. You know what to expect in terms of risk and return when you invest in an index fund. Having a portion of your portfolio in index funds leaves you free to concentrate your investment time and energy (think alpha waves) on those investments which can make a difference. Picking high alpha investments, which by their nature are less correlated with the stock market, should reduce the risk/volatility of your portfolio and, depending upon the investment, provide above market returns. 

There was an excellent article discussing the pros and cons of investing in ETFs in the July 3^rd Wall Street Journal: As ETFs Seek Niches, Risks Rise (unfortunately, The Wall Street Journal doesn’t allow us to link to their articles, perhaps that will change after Rupert Murdoch buys Dow Jones.) There’s over $500 billion invested in ETFs and, I believe, they will either replace open-end index mutual funds or force those funds to lower their expenses. A win for investors. ETFs generally have lower on-going expenses then index mutual funds. You’re charged a commission to buy or sell them, as for a stock, but the commission may be less then the fee charged by your broker, or fund, for buying a mutual fund (consider the share class you’re buying). ETFs are priced, and traded hourly, not at the end of the day as with open-end mutual funds.

 

ETFs are excellent tracking vehicles for many different kinds of investments. Want to invest overseas? In commodities? Buy an ETF. (Not to get carried away, there are index funds that track most of the indices that do ETFs.)

 

So what’s not to like about ETFs? Going back to The Wall Street Journal article, Lipper, which tracks fund performance, reported that a disproportionate number of ETFs showed up on its losers (poor performing) list. For some ETFs it is simply a case of tracking a narrow and volatile index, nanotechnology, for example. The lesson here is that investors need to consider the riskiness of any investment they’re making. An ETF doesn’t diminish the risk of a cutting-edge technology, volatile commodity, or stock market of an emerging country. What a good ETF will do is reflect the performance of whatever index its is designed to track.

 

Like most new products, and ETFs are a new product, there will be some product-specific risks as well. Some ETFs won’t track their underlying index due to design error or too narrow a portfolio. Costs won’t automatically be less, turnover and taxes will be issues for some ETFs. To mitigate these risks stick with ETFs issued by well-known institutions.  

 

Vanguard, the godfather of index funds, has joined the ETF party and is coming out with more. (See When is a Door Not a Door for more information on ETFs and what John Bogle, the founder of Vanguard, thinks of them.) Vanguard’s action is perhaps the best evidence to date of the rise of ETFs.

 

The moral to the story is to consider ETFs whenever you’re considering an index fund or want a low cost and liquid way to obtain exposure to a particular type of investment. Just remember that an ETF doesn’t reduce the risk of the investment class.

My partner and I had lunch with the person who runs one of the preeminent university finance reach centers in the U.S. (really, in the world). He had three (okay, seven) words of wisdom for investing in the stock market: S&P index funds, small cap stock funds and momentum. Let’s take them one at a time.

 

Index funds, as championed by John Bogle and Vanguard, are a way for the investor to track the performance of the market. Indexers argue that most investors can’t beat the market and end up under performing and paying higher fees trying. According to our research guru, all S&P index funds show the same performance, the only difference being expenses, so pick the fund with the lowest expense ratio. 

 

The market for small cap stocks is less efficient due to the more volatile nature of small companies and less analyst coverage. Thus, an insightful mutual fund manager can outperform a small cap average (what would go into that average is not clearly defined, unlike the S&P 500).

 

Momentum is the concept that stocks will continue to move in the same direction over the short term due to technical and/or fundamental factors. It is a difficult and risky investment strategy for a mutual fund investor, but a good small cap stock manager will have this tool in his or her arsenal.

 

One of my rules for success is to listen to those who are richer and/or smarter than I am. I don’t know my friend’s net worth but I do know that he is a heck of a lot smarter than me. You won’t go wrong following his advice in managing your domestic equity portfolio – make an S&P index fund your core holding and supplement it with a couple of good small cap funds. (See MUTUALdecision’s Top Ten lists of small cap stocks.)