Buy Index Funds — And Managed Funds

11/21/2011


Should you buy index funds or actively managed funds? The short answer is to buy both.

Index funds have some compelling features, including low costs and tax efficiency. But many actively managed funds also have those qualities — and the potential for market-beating returns. The Forecasts' recommended portfolios include both types of funds.

Mostly because of their lower expenses, index funds tend to outperform their actively managed counterparts over the long haul. A study by index-fund giant Vanguard found that roughly 62% of U.S. stock funds underperformed the broad market in the 10 years ended 2010. About 71% of bond funds underperformed the bond market during the period. 

Index funds have had the upper hand in 2011. Based on the returns of 1,312 large-cap stock funds through Oct. 31, roughly 73% had underperformed the S&P 500 Index's 1.3% return. Over the same period, 61% of midcap funds trailed the S&P MidCap 400 Index, while 77% of small-cap funds lagged the S&P SmallCap 600 Index. Among intermediate-term bond funds, 67% lagged the return of the Barclays Aggregate Bond Index.

But while it's tempting to go all index, investors should not abandon actively managed funds. Some portolio managers can add value and deliver market-beating returns. Take T. Rowe Price New Horizons ($36; PRNHX), our favorite small-cap fund, which has outpaced the Russell 2000 Index in three of the last four years. At 31%, its three-year annualized return tops the Russell 2000 gain of 19%.

Moreover, holding both index and actively managed funds can help diversify your portfolio. As illustrated below, active management wins out in some periods. The table shows the percentage of U.S. stock funds that underperformed their style benchmark for a given five-year period. For example, about 65% of large-cap blend funds lagged their benchmark for the five years ended 2010. But for the five years ended 2005, only 32% of large-cap value managers fell short of their benchmark.

RELATIVE PERFORMANCE OF ACTIVELY MANAGED FUNDS
The table below shows the percentage of U.S. stocks funds that underperformed their category benchmark. For example, in the five years ended 2010, roughly 50% of large-cap value funds trailed their benchmark. That same year, 65% of large-cap blend funds underperformed, while 76% of large-cap growth funds lagged. Source: Vanguard.
Five Years Ended
2002
(%)
2003
(%)
2004
(%)
2005
(%)
2006
(%)
2007
(%)
2008
(%)
2009
(%)
2010
(%)
Avg.
(%)
Large-Cap
Value
40
39
29
32
70
79
71
51
50
51
Blend
57
46
41
55
63
70
64
61
65
58
Growth
55
38
50
71
63
46
57
65
76
58
Midcap
Value
81
71
80
94
97
77
75
63
50
76
Blend
72
64
67
69
82
82
74
67
61
71
Growth
90
81
80
85
85
76
47
53
49
72
Small-Cap
Value
41
41
49
35
53
73
60
50
46
50
Blend
55
50
45
60
71
81
57
63
67
61
Growth
56
64
81
86
90
81
74
80
82
77

Rather than dwell on active versus passive management, investors should focus on fund expenses, which are easily identifiable and controllable. Studies have shown that the expense ratio is the single most reliable predictor of future returns, with low-cost funds consistently delivering the best returns. Among our 20 recommended funds listed below, 19 charge fees below the average for their categories.

RECOMMENDED MUTUAL FUNDS

Through Nov. 15, our recommended Growth Portfolio has lost 2.1% so far this year, versus a 1.6% loss for its benchmark portfolio. The Conservative Portfolio is down 0.3%, versus a 0.1% loss for its benchmark.

Year-to-Date
% of Portfolio
Fund (Price; Ticker)
Return
(%)
Rank
Conser-
vative
(%)
Growth
(%)
Fund
Rating
American Century Heritage
($21; TWHIX)
(2.3)
D
6
7
62
Buffalo Growth
($26; BUFGX)
3.2
B
10
11
89
Dreyfus MidCap Index
($28; PESPX)
(1.1)
B
0
0
85
Dreyfus Small Cap Stock Index
($20; DISSX)
(0.2)
A
0
0
52
Heartland Select Value
($28; HRSVX)
(4.7)
D
4
6
75
Homestead Small Company
($23; HSCSX) NEW
(0.4)
A
5
6
100
Manning & Napier International
($8; EXITX)
(10.3)
B
7
7
87
T. Rowe Price New Horizons
($36; PRNHX)
6.5
A
7
7
98
Vanguard 500 Index
($116; VFINX)
1.7
A
5
5
71
Vanguard Dividend Growth
($15; VDIGX)
7.1
A
10
11
99
Vanguard Emerging Mkts.
Stock Indx. ($26; VEIEX)
(14.0)
C
0
4
92
Vanguard GNMA ($11; VFIIX)
6.5
B
10
5
90
Vanguard Inter.-Term Tax
Exempt ($14; VWITX)
7.1
B
0
0
56
Vanguard Short-Term Invest.
Grade ($11; VFSTX)
1.9
B
7
6
91
Vanguard Total Bond Mkt. Index ($11; VBMFX)
6.7
A
10
0
63
Vanguard Total Int'l Stock
Index ($14; VGTSX)
(12.0)
C
4
4
91
Vanguard Wellesley Income
($23; VWINX)
7.5
A
0
0
99
Vanguard Wellington
($31; VWELX)
2.4
A
6
9
96
Wasatch International Growth
($18; WAIGX)
(8.6)
B
4
6
96
Wells Fargo Advantage High
Income ($7; STHYX)
3.2
A
5
6
59
* Year-to-date ranks through Nov. 15 from Morningstar, comparing performance among funds with same objectives. A = top 20%; B = next 20%; C= middle 20%; D = next 20%; E = bottom 20%. Fund ratings are percentile ranks based on our fund-rating system. NEW Addition to list.

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