Funds that ride a wider wave

Investors bullish on US economy at large look closely at a range of index funds

Looking to ride along with what appears to be an economic rebound - but you're not quite sold on any particular sector?

When you own an index mutual fund, you own shares in every firm that's listed in whatever stock-market index - including some very broad ones - the fund follows.

Assuming the stock market continues to creep back up, so too will index funds, which mirror the direction of the market.

"This is probably not a bad time to buy into the market," says Russ Kinnel, who heads up equity research for financial information firm Morningstar, Inc., Chicago. "And it is an especially good time to buy funds with very low expenses."

Index funds tend to have inexpensive cost structures, Mr. Kinnel notes, because their managers lean heavily on computer programs. The typical index fund has an expense ratio - the fraction of the value of your fund you'll be charged for the cost of maintaining it - of about 0.2 percent.

The Vanguard Index 500 fund, perhaps the best-known index fund, has an expense basis of only 0.18 percent, for example. The Fidelity Spartan Index 500 Fund comes in at 0.19 percent.

By contrast, the typical stock-equity fund has an expense ratio of about 1.2 percent. Its manager must constantly go into the fund portfolio, buying and selling companies. That adds operating costs.

Index funds also have minimal tax consequences, since there is very low turnover in terms of companies entering and leaving. (Each such transaction also means a tax hit for the fund, which is passed along through expenses and fees.)

A core holding with clout

For the average investor, buying into an index fund has never been easier. Currently, there are 491 of them in the US, including multiple share classes, according to Morningstar. Some 460 of the funds are equity funds; 31 are bond funds.

Of the stock funds, about 150 are linked to the Standard & Poor's 500 stock index, which tracks the 500 largest companies in the US. Others are linked to the giant 30 industrial companies of the Dow Jones Industrial Average, and the total stock market, tracked as the Wilshire 5000.

There are also index funds linked to various bond sectors, including both US and overseas bond products.

In January, the index-oriented Vanguard Group led the industry in terms of inflows, with more than $6.2 billion in new monies, according to information provider Financial Research Corp., Boston.

Vanguard's top sellers were the Total Bond Market Index Fund, the S&P 500 Index Trust, and the Total Stock Market Index Fund. (The Pimco Total Return Bond Fund, an actively managed fund, led all mutual funds in total industry sales in January.)

"An index fund makes a very good core holding for a person's portfolio," says fund expert Sheldon Jacobs, who publishes the No-Load Fund Investor, Ardsley, N.Y.

Mr. Jacobs, who tracks several model portfolios for his clients, likes to index 40 percent to 50 percent of equity holdings.

Jacobs finds a total-market index - like the Wilshire - to be the best play among index funds. The S&P 500 index comes close to duplicating that depth, he says. Kinnel, of Morningstar, agrees: Go broad.

Over time, index funds tend to fare better than actively managed funds, studies have shown.

According to an analysis by Ted Cadsby, then president of CIBC Securities Inc., in 15 of the years between 1983 and 1999, less than half of all US stock fund managers beat the Standard & Poor's 500 Index.

What to watch for

So is there a downside to the index strategy? Critics say investors should strive to beat the market, not just to equal it.

And even backers of index investing note that firms are constantly being added and deleted from indexes, opening the way for the occasional clunker that might throw off the fund's performance.

Also, some index-fund managers have been known to make trades on their own, bolstering positions in one of the fund's holdings, for example, to try to get a boost from a "hot" company.

In some cases, managers will even reach outside of the index for buys, though they are limited by law from taking this approach too far. At some point, their products would become what are known as enhanced index funds, only loosely based on indexes.

It pays to be alert to what a manager is doing, say experts. Adding firms to an index fund (or removing them) can enhance a given fund's performance. But it can also raise expenses and eat into earnings if the new stocks' gains fail to materialize.

It can be useful to check out a fund-tracking website like Morningstar.com before choosing your index fund. If a fund's performance deviates too much from the index it purports to follow, its manager might be doing too much tweaking, experts say.

Their overseers might rely heavily on computers, but these funds can still falter.

"Indexes are not perfect," says Jacobs with a laugh.

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