Should You Mess with a Winning Recipe? Today an investor can buy indexed mutual funds in virtually any flavor. But the truth is, it's tough to improve on the original.
By Lynn O'Shaughnessy

(Business 2.0) – Ever think about topping a cheeseburger with caviar? Dropping a Ferrari engine into a sensible little Honda Civic? It doesn't sound especially rewarding--but exactly that kind of upgrade has come to the staple of commonsense portfolio management, the index fund. Today you can purchase index funds that track hot companies in the Middle East, mirror the returns of the riskiest tech stocks, or double the gains (or losses) of the S&P 500. It's only a modest exaggeration to say that you can now use an index fund to act on just about any hunch you might have on the direction of the market. The only problem is, that's the last thing index funds were created for.

After all, the idea behind indexing is that playing hunches is, in the long run, a loser's game. No investor can outsmart the market forever, the theory goes, so even the savviest pro's performance will eventually converge with that of the mediocre money manager. The classic index fund, in other words, is the perfect vehicle for once-burned, twice-jaded investors. Rather than scramble for top-of-the-chart returns, its holdings merely ape the movements of the stock market as a whole, as represented by a yardstick like the S&P 500 or the Wilshire 5,000.

Such an investing style may not make for especially exciting coffee-break conversation, but the results have been compelling: During the past decade, 82 percent of actively managed large-cap funds failed to beat the S&P 500-tracking Vanguard 500 Index fund, according to fund researcher Morningstar. So settling for average actually means consistently beating the average fund.

This bothers mutual fund companies--not just because of what it implies about the typical fund stockpicker's skill, but also because of what it does to funds' profit margins. After all, a traditional index fund, by definition, can compete only on price. So a number of mutual fund companies decided to take the plain-Jane indexing concept and sex it up. Some of these new products do add real value. So-called exchange-traded funds (ETFs), for example, are essentially index funds with the flexibility to trade like stocks. Many other new index funds, however, are based on rather dubious investing logic, even if their business purpose is crystal-clear. "They're selling these things not because they're useful, but because they'll sell," says William Bernstein, author of The Four Pillars of Investing and a devotee of traditional indexing. "Many of them are the investment equivalent of junk food."

How do you tell the difference between the real beef and a bunch of empty calories? The answer lies both in how your index fund is designed and in how you'll use it in a portfolio. Here are the principles to follow:

Go broad.

Nearly any sector that might tickle an investor's fancy now claims its own index fund, from iShares Goldman Sachs Networking to Vanguard's Consumer Staples Vipers. Keen on tech stocks? The iShares Goldman Sachs Technology Index, which tracks companies that the investment bank sees as important, has jumped 24 percent since its 2002 low. Of course, the bad news is that the fund launched in 2001, when tech stocks were 150 percent higher than they are now. "Sector investing gives consumers the opportunity to be foolish by chasing what's hot," says Larry Swedroe, director of research at Buckingham Asset Management in St. Louis.

Swedroe says the problem with sector index funds is that you have to guess right on the sector--and nobody does that consistently. You're much more likely to avoid disaster by sticking to index funds that buy broad classes of stocks. An index fund that follows the S&P 500, like Vanguard's 500, exposes you to about 70 percent of the value of the stock market, in sectors ranging from health care to utilities.

Get the most investment for your money.

Some of today's index funds can give you sticker shock. For instance, ProFunds's tiny UltraBull, which purchases futures and options to deliver returns that are twice as volatile as the S&P, will cost you at least 1.7 percent of your investment annually. That's about 10 times the 0.18 percent charged by the Vanguard 500. The high fare is justified, ProFunds says, by the managers' complex derivative work. Maybe. But all that number crunching has certainly succeeded in making the fund riskier. In 2001 and 2002, the fund plummeted 78 percent. In 2003, it rebounded 53.4 percent. Just understand what you're getting into.

Think through the tax angles.

There's another reason to stop short before buying an index fund, and that's to consider an ETF. Unlike investors in conventional index funds, long-term holders of ETFs don't pay for capital gains incurred by other holders who sell their shares. Hence, ETFs run up less of a tax bill than index funds if you leave the money untouched for about five years.

Yet the ETF approach to indexing really only works if you're socking away money all at once. That's because the downside to ETFs' stocklike qualities is that you have to pay a broker's commission every time you buy in. So if you inherit a tidy sum that you envision someday retiring on, consider putting it into an ETF like, say, Vanguard's Total Stock Market Vipers. But if you dollar-cost average--a steadfast approach that calls for investing a fixed amount of money regularly--you're better off investing in a regular no-load index fund.

Dollar-cost averaging into a fund that prospers by being average: It's a simple tactic that historically has worked extremely well. Why complicate things?

Freelance writer Lynn O'Shaughnessy is the author of "The Investing Bible."