The Best Way to Invest in Index Funds

Investors’ passion for indexing these days reminds us of a classic Cole Porter lyric: “Birds do it, bees do it, even educated fleas do it.” Yep, everybody, it seems, is falling in love—with index funds. Since 2010, investors have withdrawn a net sum of $500 billion from actively managed U.S. stock funds and invested that amount and more in index-tracking mutual funds and exchange-traded funds. But one of the cardinal rules of investing is that whenever everyone agrees on something, chances are high that just the opposite will occur. So could indexing be the wrong way to go?

The answer: yes and no. The benefits of indexing are indisputable—the strategy is cheap, it’s transparent, and it’s no-fuss (once you’ve decided which benchmarks you want to track). And in recent years, indexing has worked particularly well with the world’s most widely mimicked benchmark, Standard & Poor’s 500-stock index. Over the past five years, the S&P 500 generated a cumulative gain of 98% (14.7% annualized). During that period, only 14% of actively managed, large-company mutual funds beat the index. (All returns are through December 31.)

But indexing has its shortcomings, too. It’s not as effective in some categories as it is for large-capitalization U.S. stocks. If you index, you cannot beat the market; actively run funds at least give you the chance to outpace a benchmark. Plus, says Daniel Wiener, editor of the Independent Adviser for Vanguard Investors newsletter, “good timing” is required even in indexing. In particular, this may not be the best time to hitch your wagon to the S&P 500, which is what many people think about when they consider indexing. Indexing’s defenders may scoff, but there have been times—long stretches, even—when active managers dominated their benchmarks.

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In the end, your best strategy may be to own a combination of index and actively managed funds. Choosing good active funds is key, of course. The other trick is knowing which markets or market segments are best suited to indexing, and in which slices active funds stand a better chance of winning. Below, we tell you where to index and where to go active.

The indexing advantage

The price is right. Index funds buy and sell securities less frequently than actively managed funds, so they incur fewer trading costs. More important, index funds charge substantially lower fees. The expense ratio for the typical actively managed large-company stock mutual fund is 1.13%. But mutual funds and ETFs that track large-cap U.S. stock indexes cost 0.49%, on average, and many charge far less.

A fee differential that typically exceeds one percentage point per year “is a high bar for active managers to overcome,” says Todd Rosenbluth, at CFRA, a stock and fund research firm. And over time, the cost advantage adds up. “Albert Einstein called compound interest the eighth wonder of the world,” says Daniel Wallick, a portfolio strategist at the Vanguard Group, the firm that invented index funds for individual investors. “But costs compound, too.”

Fees aren’t the only obstacle for active managers. For one thing, the growing speed with which information is disseminated and the sheer number of talented active managers makes it hard for any of them to stand out. Last year, for instance, 1,117 actively run funds, most run by “highly skilled managers,” in the words of Morningstar analyst Ben Johnson, jockeyed for position in the domestic large-cap category.

Recent market conditions haven’t helped. Tepid economic growth combined with persistently low interest rates created a “weird” market, says Rob Sharps, co-head of global stocks at T. Rowe Price. Narrow slices of the market often drove returns: In 2014 and 2015, shares of large companies trounced those of small companies as investors sought shelter in what they presumed to be sturdier firms. Active large-cap managers who dared to invest in smaller companies were, more often than not, penalized for straying.

Making matters worse for human stock pickers (as opposed to the computers that essentially run index funds), narrow segments drove the market’s performance. That was most obvious in 2015, when a small group of fast-growing technology companies—namely, Facebook, Amazon.com, Netflix and Alphabet (then called Google)—made the difference between a fund beating the S&P 500 or lagging it. “That’s a tough environment for active managers,” says Sharps.

Some strategists say active managers have struggled of late because the difference between the returns of stocks within the S&P 500 and that of the index—the so-called dispersion rate—has been historically low since 2010. In other words, the gap between the best and the worst performers in the index has narrowed. But rising interest rates, a growing belief that inflation is heading higher and a maturing economic cycle could mean higher dispersion levels in the coming year, giving active managers a better chance to beat the S&P 500. Against this backdrop, “2017 could be the year of the active investor,” says Candace Browning, head of Bank of America Merrill Lynch Global Research.

Whether or not Browning is right, 2017 wouldn’t be the first time that active managers beat their benchmarks. The bulk of active large-cap U.S. stock fund managers also beat the S&P 500 in 2007, 2009 and 2013. Active investing has even prevailed over long stretches. From 2000 through 2009, the S&P 500 surrendered 1.0% annualized. During this so-called lost decade, 63% of actively run large-cap stock funds beat the index, with an average annualized return of 2.4%.

Because traditional benchmarks weight their holdings by market value—the bigger the capitalization, the bigger its spot in the bogey—index investors are vulnerable to bubbles. A classic example came in the late 1990s and early 2000, when investors pushed up tech stocks to absurd levels. When the bubble burst, investors in S&P 500 index funds got crushed even as funds that focused on undervalued stocks and small-cap funds made money. The “Achilles heel of market-cap-weighted index funds,” says Johnson, is that you’re fully exposed to market manias.

The best places to index

Of course, there is more to indexing than the S&P 500. Among other well-known benchmarks are the Russell 2000, which tracks small-company stocks; the MSCI EAFE, which is synonymous with large-cap stocks in developed foreign lands; and the Bloomberg Barclays US Aggregate Bond (AGG), which is the standard index for investment-grade U.S. bonds.

To assess which areas are better-suited for indexing and which are more amenable to active management, we pored over data from Morningstar and S&P Dow Jones Indices that pit actively managed funds in stock and bond categories against their index-fund counterparts or against indexes themselves. With help from Morningstar, we also ran our own screens to study assorted stock and bond categories over various time frames.

Our findings? Some fell in line with what most market watchers say about indexing: In efficient markets—those classes of stocks or bonds that are closely watched and easy to trade—go with index funds. In less-efficient markets, choose actively managed funds. So, within the U.S. market, indexing works best with large-company stocks. But go active with funds that focus on stocks of small or midsize companies. Morningstar has found that low-cost, actively managed small-cap stock funds, in particular, have done a good job of beating their index-fund peers.

The same has been true on the foreign stock side. Most active funds that invest in small and midsize foreign stocks have outpaced their respective indexes over 10 years. Their large-cap brethren have not.

Finally, investment style has mattered, too. Morningstar and S&P data show that over the long haul, active value-oriented funds that invest in large-, midsize- or small-company stocks had better success in outpacing their benchmarks than their counterparts that invest in fast-growing companies or whose holdings exhibit a blend of growth and value attributes.

Bonds are trickier. Conventional wisdom holds that bonds are horribly suited to indexing. The Bloomberg Barclays AGG index contains thousands of securities, and not all of them trade daily, making them hard to price accurately. Moreover, bond index funds tend to hold a representative portfolio, using a technique known as sampling, that attempts to mimic the benchmarks they track. This can sometimes lead to differences in performance between bond index funds and their benchmarks.

Active bond fund managers can attempt to add value by investing outside of the benchmark’s restriction to investment-grade debt. But what separates them from bond indexers is their ability to adjust their portfolio’s sensitivity to swings in interest rates. That’s critical because as rates fall, bond prices generally rise, and as rates increase, bond prices generally decline.

These days, with rates on the rise, the AGG looks especially vulnerable. Its duration, a measure of rate sensitivity, is 5.9 years. That implies that if interest rates rise by one percentage point, the index will lose 5.9% of its value. If you hold a US Aggregate Bond index fund, you’re stuck with that. But an active intermediate-term bond fund manager can soften the blow of rising rates by buying shorter-maturity debt, among other moves.

As it turns out, investors have been better served by going active with funds that focus on medium-term, high-grade bonds. Active intermediate-term bond funds had the highest 10-year success rate of all the fund categories that Morningstar scrutinized.

In other areas of the bond market, the results for active fund managers have been mixed, says Aye Soe, senior director of global stocks at S&P Dow Jones Indices. “It’s all over the map, depending on whether managers get the interest-rate call right or not.”

A little bit of both

The smart way to invest is to own a combination of index funds and low-fee, actively managed funds. In fact, that’s how most Americans invest their money, says Johnson, of Morningstar.

On the stock side, the best way to assemble a portfolio is to establish a core that consists of an index fund that tracks the S&P 500 or one that copies a total-market benchmark. The Kiplinger ETF 20 includes both options: iShares Core S&P 500 (symbol IVV) and Vanguard Total Stock Market (VTI).

Then complement your index funds with a couple of actively managed large-company-oriented stock funds. Two stalwarts of the Kiplinger 25, the list of our favorite mutual funds, are Dodge & Cox Stock (DODGX), which seeks bargain-priced stocks and charges just 0.52% annually, and Mairs & Power Growth (MPGFX), which focuses more on growth-oriented companies and charges 0.65% a year.

Fill out the small- and mid-cap portion of your portfolio with actively run funds. Standouts include Kiplinger 25 members T. Rowe Price Small-Cap Value (PRSVX) and Parnassus Mid Cap (PARMX).

For foreign stocks, start with a diversified index fund. A solid choice is Vanguard Total International Stock (VXUS), a member of the Kip ETF 20. Then add two members of the Kiplinger 25, FMI International (FMIJX) and Fidelity International Growth (FIGFX). Their expense ratios—0.94% and 0.96%, respectively—are below-average for actively run overseas funds. If you believe in the long-term case for emerging-markets stocks (admittedly, their mediocre performance in recent years has made it harder to do so), split your money between iShares Core MSCI Emerging Markets ETF (IEMG) and Kip 25 member Baron Emerging Markets (BEXFX). Although the ETF charges just 0.14% annually, Baron’s expense ratio of 1.45% is on the high side.

For bonds, build a core of good active funds, such as DoubleLine Total Return Bond (DLNTX), Metropolitan West Total Return Bond (MWTRX), Pimco Income (PONDX) and Vanguard Short-Term Investment-Grade (VFSTX). If you can tolerate more risk, add Vanguard High-Yield Corporate Fund (VWEHX), which takes a conservative approach to investing in junk bonds.