Always A Place For Index Funds

12/19/2016


Each year since 2005, more money has flowed into stock index mutual funds and exchange-traded funds (ETFs) than into actively managed funds. Critics contend that index investors are simply settling for average returns. So why would anyone own one?

Fans of passive investing offer at least two reasons: First, index funds are difficult to beat. So far in 2016, less than one-third of actively managed large-company stock funds have outpaced the S&P 500 Index. Long-term performance is even worse. For the 10 years ended June, only 15% of large-cap stock funds outperformed the S&P 500, according to Standard & Poor's. Fewer than 10% of midcap and small-cap funds outpaced their respective S&P indexes.

Second, index funds usually have low expenses and portfolio turnover, which put less drag on performance. For example, index funds that track small-cap stocks have an average expense ratio of only 0.60%, compared to 1.32% for managed funds. Research has shown that expense ratios are the best predictors of future fund performance. Index funds are also generally more tax-efficient, helping boost after-tax returns.

To be sure, the surge of indexing has some investors worried, partly because the funds wield increasing clout. A study by The Wall Street Journal found the percentage of S&P 500 stocks owned by passive funds has more than doubled since 2005, to nearly 12%. Critics argue that index funds pile into stocks regardless of a company's fundamentals or growth opportunities, potentially allocating capital to poorly managed firms.

Making matters worse, stocks included in indexes tend to trade at a growing premium valuation compared to stocks left out. For example, research by S&P Capital IQ last year found that stocks in the Russell 2000 Index traded at a more than 60% premium to stocks outside the index, up from 12% in 2006.

And as investors increasingly abandon managed funds, questions arise about the long-term outlook for passive funds. Managed funds are needed to make passive investing work, as index funds get a free ride from the relatively efficient pricing of stocks and bonds provided by active managers.

Still, for all the talk about index funds, Morningstar estimates that about two-thirds of assets in mutual funds and ETFs are actively managed. Vanguard itself, the poster child of passive investing, oversees nearly 140 actively managed mutual funds that hold some $1.2 trillion in assets.

Our advice — buy both

A lot of investors are asking if they should pick an active or passive strategy. In our view, the two are complementary. Case in point: Among our 20 recommended funds listed below, 11 are actively managed.

There are always actively managed funds that beat index funds. Historically, active managers have the upper hand during choppy or bear markets, when stock-picking takes on more importance or defensive maneuvering is required. In addition, smart managers can add value in less-efficient markets, including small stocks and foreign securities. Take Fidelity Overseas ($41; FOSFX), our top pick among foreign funds, which has outpaced the MSCI EAFE Index of foreign stocks in four of the last five years. The fund's five-year annualized return is 10.8%, outstripping the index gain of 7.0%.

Still, mostly because of their low cost, index funds tend to outperform over time, particularly during long-running bull markets like the current one. To that end, below we highlight 40 index funds in 20 popular categories. We include traditional funds and ETFs selected using our fund-rating system, which favors cheap funds with strong track records.

40 top index funds
-- Total Return --
Category
Fund (Price; Ticker)
Year-
To-Date
(%)
3-Year
Annual.
(%)
Expense
Ratio
(%)
Fund
Rating
Balanced
iShares Core Growth Allocation ($41; AOR)
7.2
5.1
0.25
86
Vanguard Balanced ($32; VBINX)
9.4
7.3
0.22
98
Diversified emerging markets
Schwab Emerg. Mkts. Equity ($22; SCHE)
15.6
(0.3)
0.13
97
Vanguard Emerg. Mkt. Stock ($23; VEIEX)
13.5
(0.7)
0.33
86
Foreign large-cap blend
Vanguard FTSE Developed Mkt. ($37; VEA)
4.2
0.9
0.09
91
Vanguard Total Int'l ($15; VGTSX)
6.1
0.5
0.19
86
Foreign large-cap value
Schwab Int'l Large Co. ($8; SFNNX)
9.4
1.1
0.35
95
WisdomTree Int'l Equity ($47; DWM)
4.3
0.6
0.48
85
Foreign small/midcap blend
iShares MSCI EAFE Small-Cap ($51; SCZ)
2.9
3.5
0.40
88
Schwab Int'l Small Co. ($12; SFILX)
10.3
4.9
0.49
100
Intermediate-term government bond
Northern U.S. Treasury ($21; BTIAX)
0.5
1.8
0.16
73
Vanguard Inter.-Term Gov't ($64; VGIT)
0.8
2.0
0.10
86
Intermediate-term bond
Vanguard Inter.-Term ($84; BIV)
2.6
3.4
0.09
85
Vanguard Inter.-Term ($11; VBIIX)
2.5
3.3
0.16
83
Large-cap blend
iShares Morningstar Lrg.-Cap ($135; JKD)
14.8
11.1
0.20
100
Schwab Total Stock Market ($41; SWTSX)
14.1
10.3
0.09
86
Large-cap growth
SPDR S&P 500 Growth ($107; SPYG)
8.2
10.8
0.15
97
Vanguard Growth ($58; VIGRX)
7.6
9.6
0.22
87
Large-cap value
Vanguard Mega Cap Value ($68; MGV)
17.8
11.3
0.09
99
Vanguard Value ($37; VIVAX)
18.2
11.2
0.22
96
Midcap blend
iShares Core S&P Mid-Cap ($168; IJH)
22.5
11.0
0.07
100
Northern Mid Cap ($19; NOMIX)
22.4
10.9
0.15
93
Midcap growth
Vanguard Mid-Cap Growth ($108; VOT)
8.7
8.4
0.08
92
Vanguard Mid-Cap Growth ($42; VMGIX)
8.5
8.3
0.20
NA
Midcap value
Vanguard Mid-Cap Value ($100; VOE)
18.0
11.2
0.08
93
Vanguard Mid-Cap Value ($39; VMVIX)
17.8
11.0
0.20
91
Real estate
Schwab U.S. REIT ($41; SCHH)
5.8
14.1
0.07
85
Vanguard REIT ($28; VGSIX)
7.8
13.5
0.26
57
Short-term government
Fidelity Short-Term Treasury ($10; FSBIX)
0.7
0.7
0.20
63
Vanguard Short-Term Gov't ($61; VGSH)
0.7
0.6
0.10
91
Short-term corporate bond
Vanguard Short-Term Corp. ($22; VSCSX)
2.5
1.9
0.07
NA
Vanguard Short-Term Corp. ($79; VCSH)
2.3
1.8
0.10
99
Small-cap blend
Dreyfus Small Cap Stock ($32; DISSX)
27.4
11.1
0.50
93
iShares Core S&P Small-Cap ($139; IJR)
28.2
11.5
0.07
99
Small-cap growth
SPDR S&P 600 Smll. Cap Gro. ($209; SLYG)
23.2
11.2
0.15
98
Vanguard Small Cap Growth ($38; VISGX)
12.6
6.2
0.20
70
Small-cap value
Vanguard Small Cap Value ($30; VISVX)
26.1
11.5
0.20
95
Vanguard Small-Cap Value ($122; VBR)
26.3
11.6
0.08
98
World stock
Northern Global Sustainability ($12; NSRIX)
9.0
5.8
0.31
92
Vanguard Total World ($62; VT)
10.3
5.5
0.14
94
• Forecasts recommendation.   † Exchange-traded fund.   Notes: Total returns through Dec. 13.

Two of our favorite index funds are profiled below.

Vanguard Small Cap Value ($30; VISVX) ranks among the top 12% of its peer group for three- and five-year total returns. Boasting a fund score of 95, the portfolio tracks the CRSP U.S. Small Cap Value Index. With nearly 860 stocks, major sector weightings include financials (19% of assets) and industrials (18%). So far this year, the fund has risen 26.1%. At 0.20%, the expense ratio is well below the category average of 1.33%.


A standout in the large-cap growth category, Vanguard Value ($37; VIVAX) holds 320 stocks, with Microsoft ($63; MSFT) the largest position at 4.5% of assets. With a fund score of 96, the fund has gained 18.2% in 2016, versus 16.4% for its category. Its five-year annualized return is 16.0%, compared to 13.9% for peers. The expense ratio of 0.22% is 81% lower than the category average.

OUR RECOMMENDED MUTUAL FUNDS

Through Dec. 13, our Growth Portfolio is up 10.6% for the year, while the Conservative Portfolio has gained 9.7%. For comparison, the growth benchmark has returned 12.1%, and the conservative benchmark is up 9.3%. Since the start of 2012, the Growth Portfolio has an annualized return of 12.0%, versus 10.9% for the Conservative Portfolio.

The Growth Portfolio, designed for long-term investors, holds roughly 65% in U.S. equities, with 16% in foreign stocks and 19% in bonds and cash. The Conservative Portfolio, geared toward investors at or near retirement, contains 58% U.S. stocks and 14% international, with about 28% in bonds and cash. Both portfolios have 14 holdings, including five index funds.

-- Year-To-Date --
Target Weights
Fund (Price; Ticker)
Total
Return
(%)
Rank
Conser-
vative
(%)
Growth
(%)
Fund
Rating
Baird Core Plus Bond ($11; BCOSX)
4.0
A
9
4
93
Dreyfus MidCap Index ($39; PESPX)
22.0
A
0
0
75
Dreyfus Small Cap Stock Index
($32; DISSX)
27.4
A
0
0
93
Fidelity Overseas ($41; FOSFX)
(0.9)
D
9
9
97
iShares MSCI EAFE Small-Cap ETF
($51; SCZ)
2.9
D
4
6
88
PRIMECAP Odyssey Stock ($27; POSKX)
14.1
B
7
8
90
T. Rowe Price QM U.S. Small-Cap
($29; PRDSX)
13.4
C
4
4
94
Vanguard 500 Index ($211; VFINX)
13.4
B
9
10
79
Vanguard GNMA ($11; VFIIX)
1.7
A
0
0
100
Vanguard Growth Index ($58; VIGRX)
7.6
B
10
11
87
Vanguard High-Yield Corp.
($6; VWEHX)
11.0
D
5
6
97
Vanguard Inter.-Term Tax Exempt
($14; VWITX)
(0.3)
B
0
0
81
Vanguard Mid-Cap Value ($39; VMVIX)
17.8
D
7
10
91
Vanguard Short-Term Invest.
Grade ($11; VFSTX)
2.6
B
9
4
100
Vanguard Small Cap Value Index
($30; VISVX)
26.1
C
4
4
95
Vanguard Strategic Small-Cap
($35 VSTCX)
22.2
C
4
4
86
Vanguard Total Bond Mkt. Index
($11; VBMFX)
2.1
D
0
0
49
Vanguard Value Index ($37; VIVAX)
18.2
B
9
10
96
Vanguard Wellesley Income
($26; VWINX)
8.1
B
0
0
100
Vanguard Wellington ($40; VWELX)
11.7
A
10
10
98
* Through Dec. 13. Ranks compare funds with same objectives: A = top 20%; B = next 20%; C= middle 20%; D = next 20%; E = bottom 20%. Fund ratings are percentile ranks, with 100 the best.

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