(MONEY Magazine) – Even a dart-throwing chimpanzee can select a portfolio that performs as well as one chosen by the experts." That devastating verdict from Princeton finance professor Burton Malkiel's classic book, A Random Walk Down Wall Street, sums up the theory that led to the creation of index funds. If highly skilled professional investors can't beat the market--and 1998 was, after all, the fifth year in a row that most funds trailed Standard & Poor's 500-stock index--then what's the point of having your money touched by human hands at all?

Now, more than ever, index funds--those baskets of stocks assembled automatically by computers--are on fire. If you'd invested $10,000 in the Vanguard 500 Index at the beginning of 1995, you'd have had just under $29,000 by the end of 1998--almost tripling your money in four years. But even that isn't good enough for everyone. For those not satisfied with the outsize performance of plain old index funds, there's a new, high-tech version. Meet the latest, trendiest fund flavor around: "enhanced" index funds. There are about two dozen of these critters, and they attracted well over $1 billion last year thanks to their scorching returns: Rydex Nova, up 35.1% in 1998; Potomac OTC Plus, up 104.5%; ProFunds UltraOTC, up 184%. "These funds have gotten a lot of exposure because of their performance," says Morningstar analyst Kevin McDevitt, "but you wonder whether people know what they're getting into."

Run by computers instead of fallible humans (or chimps), these funds appear to have a low risk of lagging the market, plus a high probability of beating it. But, like every investment idea that sounds too good to be true, that's exactly what most of these funds are.

The smell of napalm

Enhanced index funds come in several breeds. "Leveraged" funds, like those from Rydex, Potomac and ProFunds, borrow money or use derivatives to magnify the market's return when stocks are rising (and, of course, to shrink it when stocks are falling). "Tilted" funds, like Vanguard Aggressive Growth and Schwab Analytics, finesse their index, buying more of the stocks that the computer thinks are cheap and less of those it considers overpriced. And what I call "amalgamated" funds, such as Pimco Stocks Plus and Smith Breeden Equity Market Plus, attempt to augment the market's return just slightly by mixing short-term bonds with stock-index futures contracts.

It was the leveraged index funds that earned the truly outrageous returns of 1998. These funds use borrowed money and futures contracts--agreements to buy a basket of stocks at a particular price on a future date--to crank up their returns, aiming to magnify the market's moves by a target amount, say 25% or 50%. Rydex Nova, for instance, returned 35.13% last year, 22% greater than the S&P 500's 28.75%. Since futures enable a fund to control more than a dollar's worth of stocks for each dollar invested, they're a great way to pump up returns in a rising market.

But leverage hurts more on the downside than it helps on the upside. When the market goes down--and, yes, one of these days it will go down--Rydex Nova will fall roughly 50% more than the S&P. And, since it takes a 100% greater gain to pull even after a 50% bigger loss, you may never catch up to the market after it resumes rising. Responds Rydex president Skip Viragh: "The fund is a little more volatile than the index, but we feel it will catch up after a down market and surpass the S&P over time."

A "little" more volatile? In a 20% market decline, this fund would lose at least 31%. If investments were chemicals, this kind of fund would be napalm.

Tilted index funds are more like high-test. These funds use computer analysis to skew their portfolios away from the exact proportions of stocks held in a market index. Based on valuation tools like price-to-earnings ratios and analysts' forecasts, the funds load up on stocks the computer thinks are cheap and go light on those it thinks are dear. The goal is to outperform the market by a hair--say, one or two percentage points annually--while controlling risk. But in 1998 these funds didn't just tilt; some almost keeled over. Fidelity Disciplined Equity, for instance, trailed its benchmark, the S&P 500, by more than nine percentage points. Vanguard Aggressive Growth lagged its target, the Russell 2800 index of small and mid-size stocks, by 12 points. "We were pretty good at identifying bad stocks last year," says Vanguard indexing boss Gus Sauter. "The only problem is, we were buying them instead of selling them."

Amalgamated index funds, which take advantage of the way futures contracts work, are the least aggressive class of enhanced index funds. A futures contract controlling $1 million worth of stock can be bought for just $50,000 (the other 95% of the contract's value is due at expiration). That means a $100 million fund can get full exposure to the stock market for just $5 million and still invest the other $95 million in, say, short-term bonds. While the futures ensure that the fund will track the market's return, the bonds are supposed to add a smidgen more.

And in the long run, Pimco Stocks Plus' institutional shares have delivered, beating the S&P by an annual average of 0.8% over the past five years. But in 1998, the fund lagged the S&P by half a point--and Pimco's more expensive B shares (the kind that poor folk like us are stuck buying) fell behind by two full points. (Smith Breeden U.S. Equity Market Plus did a little worse.) "We're seeking to moderately outperform the market over the long haul,"explains Pimco executive vice president John Loftus, "but that doesn't mean we'll do that every year."

In my view, adding some income to augment the stock market's return does make sense--but only if the fund carries very low fees (Smith Breeden charges well under 1% annually) and only if you do not keep it in a taxable account (where this style of indexing will whomp you with big tax bills). And bear in mind that when the bond market goes bonkers, as it did in 1998, portfolios like these are all but certain to lag plain old index funds.

That is the gezornenplat

Since long before Burton Malkiel, math teachers have asserted that if you seat enough chimps in front of typewriters, one will eventually type Hamlet. In his old album, The Button-Down Mind Strikes Back!, comedian Bob Newhart imagined the lab assistants watching the simians at work: "Harry, I'm gonna check Post 14.... I don't think that poor devil is ever gonna write anything.... Harry, hold on! Post 15 here has somethin'!... Uh, 'To...be...or...not...to...be.... That...is...the... ge-zor-nen-plat.'"

Unfortunately, in my opinion, that's what happens with most enhanced index funds. Instead of getting an articulate string of market-beating returns, you get a gezornenplat: a jumble of erratic performance, higher risks, higher taxes and higher expenses.

Why settle?

Finally, my most basic objection applies if you're shopping for an enhanced index fund or even if you're just disgruntled about your actively managed funds. Why should beating the market be your primary financial goal, anyway? Sure, the average U.S. stock fund rose "only" 14% last year, while the S&P 500 went up almost 28%. But, last I checked, 14% was still pretty good money--nearly one-third higher than the long-term annual average return on U.S. stocks and more than enough to get most investors well on the way to meeting their financial goals.

If, like many people, you're still determined to beat the market because "settling" for average seems almost un-American, I suggest you think again. It's true that settling for average makes no sense if you can realistically do better. But when settling for average is a considerable step up from the alternatives, it makes all the sense in the world. I would dearly love to play basketball as well as Michael Jordan--but, frankly, I'd be delighted if I could someday settle for just being an average basketball player.

Likewise, it would be nice to find a fund that will consistently beat the market. But the odds against that are overwhelming. That's the cold, hard truth, proved by dozens of rigorous academic studies over the past three decades. So maybe we should thank our lucky stars that we can settle for average returns and focus instead on goals that are more achievable--like, say, improving our basketball games.