Buy High, Sell Higher: Index Funds Ride the Market Rocket

With the stock market pushing again to record highs, you'd expect most mutual fund investors to start dancing in the streets.

Some are; lots aren't. Most mutual funds have either sat out the Wall Street boogie or are still just a slow shuffle.

And one major exception is also the most boring type of mutual fund to own.

Index funds offer little in the way of market excitement, hot stock picks, or superstar fund managers. They just make money and are among the few staying true to the market's performance.

With talk of the Dow hitting 8000 and beyond, they look ready to continue delivering some of the best returns.

The best known among index funds try to match market performance, specifically the Standard & Poor's 500 index. They don't try to time the market nor do they actively buy and sell stocks based on their performance.

And they've become the earnings champs among US mutual funds.

Over 95 percent of all diversified stock mutual funds have trailed the Standard & Poor's 500 index this year, says Jim Raker of Morningstar, the Chicago firm that tracks mutual fund performance.

By contrast, funds that follow the S&P index (a broad measure of blue-chip stock performance) are "by and large meeting the index," Mr. Raker notes. The Vanguard 500 index fund, in fact, bettered the index. Through Tuesday, it logged a 26.2 percent gain for the year against the S&P's 24.98 percent.

Critics sometimes fault index funds for "merely" matching market averages. And even then, they sometimes fall slightly short, since standard shareholder expenses come out of total return.

But let's face it! Who would quibble with a fund that gives you most of the gain in the S&P 500, while most actively managed funds - where a manager buys and sells selected securities - struggle to post a profit?

Little wonder then that money continues to flow into index funds, more than $8 billion last year alone for the Vanguard Index 500 Trust, the largest and best known US index fund.

With over $40 billion in assets, the fund now ranks as the second-largest US mutual fund, behind Fidelity's mighty Magellan Fund, which is actively managed and boasts assets of $51 billion.

George Sauter, who manages Vanguard's index funds, expects the Vanguard 500 fund at some point to pass the Magellan Fund in assets.

Clearly, industry officials see the handwriting on the wall.

Fund families continuously add new index funds and try to make existing funds more attractive.

In June, for example, Boston-based Fidelity Investments hired Bankers Trust Co. in New York to manage its index funds, starting this fall.

This marks the first time Fidelity went outside for help to run its funds.

Morningstar now lists some 136 index funds in its data base, holding more than $115 billion in assets.

Still, financial experts caution that jumping into index funds now - with the market at historic levels - may be risky.

If stocks suddenly hit a downdraft, a lot of nervous investors could pull out of their portfolios. Unlike managed funds, index funds are fully invested, which means they have little cash on hand.

Cash is a burden when the stock market is going up because it's money missing out on the action.

But it's a benefit when the market goes down. Cash doesn't lose its value.

The absence of cash - being fully invested - actually carries a double negative for funds in a down market. If the fund's investors get panicky and start selling shares, fund managers then have to sell their investments to meet redemptions.

That creates two problems: selling stock before fund managers think it's ready, and negative capital-gains-tax impact for investors. When a mutual fund sells share of stock, all the fund's investors must pay a capital-gains-tax on any profits.

Whatever type of index fund you choose, check its annual expense fees before you invest.

Vanguard, with the industry's lowest fees, is generally considered the benchmark, with an expense ratio near 0.2 percent on total assets, compared with about 1.4 percent for most actively managed stock funds.

If an index fund has sharply higher expenses, and many do, ask why.