Index Funds Win Again

It's no secret that many Fools around the globe consider themselves fans of index investing. Here's why: Standard & Poor's reported this week that the S&P 500 index outperformed 69% of actively managed large-cap mutual funds in 2006.

The same can be said for small-cap investing. The S&P SmallCap 600 outperformed almost 64% of actively managed small-cap mutual funds.

That's another feather in the cap of index investing, adding to a historical record that's hard to beat. Over the past five years, the S&P 500 index has beaten 71% of managed large-cap funds. The S&P SmallCap 600 has beaten 78% of managed small-cap funds in the same period. (Interestingly, the S&P MidCap 400 has historically beaten 80% of actively managed mid-cap funds, but it didn't fare quite so well this year.)

What does this mean for investors? The S&P 500 outperformed managed large-cap funds by more than three percentage points, while the S&P SmallCap600 outperformed its managed brethren by almost two percentage points.

The S&P 500 index is a representative sample of 500 of the leading companies in leading industries in the U.S. economy. Some form of the index has been around since 1923. Standard & Poor's now has indexes to track virtually every market measure you could imagine, beyond simply large-cap, mid-cap, and small-cap stocks.

Among its lesser-known indexes, there's the S&P 500 Dividend Aristocrats, which measures the performance of S&P 500 index constituents that have consistently increased their dividends every year for at least 25 consecutive years. At the other end of the spectrum, there's the S&P Frontier Markets, which tracks foreign markets that tend to be relatively small and illiquid even by emerging market standards.

These and other index formulas have become the benchmark for measuring the success of actively managed mutual funds. Index funds simply try to match the index's performance. Why do Fools love index investing? It's cheap and easy.

It's cheap because investors do not have to pay a team of high-priced analysts to choose the stocks that will be included in the mutual fund. That means many index funds come without the extra fees that some mutual funds charge. Without all that overhead for salaries, research, and doughnuts for the conference table, index funds can be among the best bargains around.

It's also cheap because without all the buying and selling that takes place in a managed mutual fund, the turnover in index funds remains very low. When mutual fund managers buy and sell stocks, they pass those costs on to investors. (That's you.)

Don't take it for granted that every index fund will come with a low, low expense ratio. Some cost more than you'd think, so check for fees.

Indexing investing is also easy, because with one fund, you can literally buy the market. To do that, look for a total market index fund. (That's pretty self-explanatory, isn't it?) Consider that the market has historically returned 8% to 9% to investors annually. While that's no guarantee of future returns, you are virtually guaranteed to tap into whatever performance the broad market delivers by investing through an index fund.

It also frees you from checking up on your actively managed mutual funds to see how they're performing. Popular mutual funds that rise to the top of the heap one year often get pulled to the bottom in another. Consider Bill Miller's Legg Mason Value Trust (FUND: LMVTX  ) , whose string of outperforming the S&P 500 index finally ended in 2006, after 15 years.

That's not to say that every actively managed mutual fund should automatically be dismissed as a loser, but you will have to do your homework to sift through the offerings. For help with that, check out Shannon Zimmerman's Champion Funds, which you can peruse free for 30 days to find out which mutual funds he finds truly Foolish.

For related Foolishness:

Fool contributor Mary Dalrymple keeps her index funds in her sock drawer, and she welcomes your feedback. The Motley Fool has a disclosure policy.


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