Can You Beat Index Funds in 2009?

To reach your financial goals, simply matching the market's performance may get you there. But many found the huge losses in 2008 hard to swallow. If you want to beat the indexes, you have to figure out how to succeed where index funds fail.

One advantage of index funds is how they give you a relatively diversified portfolio of stocks in a single investment. But those who rely solely on indexed mutual funds may find themselves shocked to discover that their investments tend to be fairly concentrated in a just few sectors.

The trap of market-cap weighting
What's behind this shadow concentration? The answer lies in the way that popular market indexes like the S&P 500 get calculated.

With the exception of the Dow Jones averages, most major market indexes weigh their component stocks by their respective market capitalizations. That means that even if such an index owns hundreds or even thousands of stocks, a relatively large percentage of the fund's assets will go toward only a few top holdings. A typical S&P 500 index fund, for instance, has over 20% of its assets invested in just 10 stocks.

In addition to concentration at the stock level, index funds can own more of a particular sector than you'd like. Take a look, for example, at some recent allocations in an S&P 500 fund:

Source: Morningstar. As of Nov. 30.

Keep in mind: Those allocations already reflect most the huge drop in financials and energy stocks during 2008. The allocations constantly shift, as sectors in the S&P move in and out of favor. Historically, financial stocks alone have ranged from less than 10% to far more than 20% of the S&P 500, while energy stocks made up barely 5% of the index as recently as 2003.

Keeping an even keel
As a result of shifting trends, index fund investors get exposed to sector risk they didn't even know about. Major indexes had significant risk in financial stocks during 2006 and 2007, and in energy stocks before and during the run-up in oil prices that ended this past summer.

If you'd rather define your own level of risk, however, it's easy to go beyond a simple index fund to choose sector weightings you're more comfortable with, thanks to sector-specific ETFs.

For instance, say you want a portfolio that's evenly split seven ways across various sectors. Using sector ETFs, you could invest equal amounts in seven funds that would each give you broad diversification throughout those sectors. Here's a sample:

Source: Morningstar.

Investing in these seven funds would give you an interest in over a thousand different stocks. But unlike investing in an S&P index fund, you would be in complete control of the relative weights across sectors. If you thought financials would continue to underperform the market, you could reduce or eliminate your holdings easily. If you thought energy would rebound sharply, you could allocate more money to your energy fund.

None of this is to say that broad-based index funds aren't useful. As a one-stop way of investing in a basket of stocks that reflects the current valuations of the overall stock market, it's hard to beat the efficiency and simplicity of index funds. Moreover, their expenses tend to be lower than those of sector funds.

But if you want to beat the indexes, you have to find the companies and industries that will be the best performers. Using sector funds can give you that edge without overly complicating your portfolio. And while you may end up underperforming the indexes if you pick the wrong sectors, that's a risk you might be comfortable taking.

More on making the most of funds in your portfolio:

• Great investments for busy people.
• The most expensive ETFs you'll never need.
• The key to successful mutual fund investing.