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When and Where to Index
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In a foot race, everyone lines up at the same starting line, waits for the gun, and then runs as fast as they can toward the finish line. But when mutual funds square off against one another, index funds tend to have a slight advantage.
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That's because it usually costs less to invest in index funds than actively managed funds, which by nature require more human intervention and research (an actively managed fund is one in which a manager decides which investments to buy or sell in an attempt to improve returns or better manage risk). In many cases trading by an index fund is automated by a computer. Since costs are deducted from a fund's returns, the more-expensive, actively managed funds start further behind the starting line than index funds do.
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Index funds get another boost when things are going well. Say small-company stocks are leading the market. In that instance, a small-company index fund will usually earn more than the average small-company fund. That's because index funds focus only on their part of the market, while the average fund that purports to be a small-cap fund may in fact hold other investment types, such as large-cap stocks, mid-cap stocks, international stocks, bonds and cash. Few, if any, mutual funds are pure to one specific investment type.
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Unfortunately, the reverse also is true. When a portion of the market, such as small-company stocks, does poorly, those small-company index funds typically do worse than the average fund, which, as we mentioned above, have other holdings. In addition, index funds have no flexibility to react to changing markets. As a result if the market declines, the index will follow it down. An actively managed fund may try to put the brakes on the decline by divesting itself of poorly performing securities.
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Regardless of which fund type you decide to invest in, it is always best to do your homework and research every fund that you are considering adding to your portfolio. You can do much of that research on www.morningstar.com. However, a word of warning–just because a fund has had a good track record in the past, it doesn't mean that fund is guaranteed to do well in the future.
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