Something has happened that John Bogle probably never would have imagined in his wildest dreams: Index investing is trendy. Old-fashioned index mutual funds like Vanguard's own 500 Index Fund
It's not hard to understand why. As a previous article discussed, S&P's tracking at the end of the third quarter showed that its indices were again outperforming the majority of actively managed mutual funds in 2006, with the large-cap S&P 500 index ahead of more than 70% of large-cap funds with active management for the year. Analysis over longer periods was equally grim for actively managed funds. Although there have been other periods during which active management produced better results than the indices, the simplicity and low expenses of most index funds and ETFs makes them attractive investment choices.
The good and the bad of indexing
It's important to understand that index funds are essentially slaves to the index they happen to follow. As a result, index funds don't always make great investments. For instance, the addition of JDS Uniphase
On the other hand, one nice thing about index funds is that you always know that you're fully invested in whatever market you select, and it's easy to tell what stocks the fund owns and in roughly what proportions it owns them. With actively managed funds, on the other hand, you can never quite be sure whether they hold a particular stock; by the time a list of holdings appears in a semi-annual report, the actual companies the fund owns may have changed dramatically. Index funds are almost perfectly transparent, keeping investors from having to suffer unwanted surprises.
Taking advantage of indexing
The mindless devotion that index funds have toward changes in their target index can create opportunities for investors. When stocks are added to or deleted from an index, the company that manages the index gives notice of the addition or deletion in advance. This gives index funds and other investors time to prepare for the change. However, it also gives traders a chance to buy stock in companies that are being added to a given index before the index funds buy shares. For example, in late November, S&P announced that DirecTV
On the other hand, there may also be an opportunity to profit from stocks that get deleted from an index. If selling pressure resulting from the dropping of a stock from an index artificially lowers prices temporarily, then the stock may recover after index funds have sold out. For instance, Louisiana Pacific
For those who are content with market-matching returns, index funds do an admirable job of earning them. Even if additions and deletions to indices create inefficiencies, the effect on index fund investors is negligible; a temporary blip in a single stock in the S&P 500 may hurt fund investors by only a few hundredths of a percentage point. However, these inefficiencies may result in much bigger gains by nimble traders who seek bargains among the stocks the index funds have to sell.
Can you do better than indexing? Shannon Zimmerman, who runs the Fool's mutual fund newsletter, Motley Fool Champion Funds, thinks so -- and he's got the track record to back it up. Even though many funds can't match index funds, Champion Funds seeks out the funds whose managers have proven they can outperform benchmarks year after year. To find out more, take a free look with our 30-day trial.
Fool contributor Dan Caplinger has always been a big fan of index funds for their low expenses. He doesn't directly own shares of the companies mentioned in this article, although his stock index funds own a small piece of most of them. The Fool's disclosure policy keeps up with additions and deletions.