Time to rethink your index funds

Key Points

Index funds have been the American Idols of investing in recent years, but in today's market, they may be growing less attractive.

When the overall market was consistently climbing, investors reasoned, "Why bother paying portfolio managers to buy and sell stocks, when I can do pretty well-with less expense-in index funds?"

Since index funds track the market, that logic worked when most areas of the market did equally well. But after the more recent performance in the marketplace, active portfolio managers have an opportunity to shine.

The trick is in the selection

The 800-pound gorilla is that not all mutual fund managers choose wisely or well. While you have plenty of actively managed stock funds to choose from, you could get a fund that underperforms, or does no better than the market but has higher expenses than an index fund.

To choose a good actively managed stock fund, you can read up on fund recommendations at Morningstar.com, or use the search tools at a larger discount brokerage site. Search the funds in various categories (i.e., large blend, mid-cap, etc.), and look at each fund's historical one- and five-year track record (at least). You need a minimum of five years to get an accurate picture of performance. Make sure that the manager responsible for that track record is still at the helm. Also, check to see that the fund's returns are in the top 25 percent of its sector for five years or more.

Consider, also, the consistency of results. Pay attention to risk, too. You don't want high returns that are dependent on volatile, risky choices, because you could tank as easily as rise. Look for funds that have exceeded the sector results, yet have below-average risk.

Expenses are another key factor. Managed fund expenses are typically higher than index fund costs, due to the research, work, and expertise involved. I prefer expense ratios below 1.25 percent unless the fund has something special to offer. International funds and more complex funds (like those that use hedge techniques) require more management, and expenses may be up to about 2 percent.

Two managed funds worth looking into are Third Ave Value Fund (focusing on mid-cap stocks), which has performed well in all kinds of markets over a length of time, and Longleaf Partners Fund. Manager Mason Hawkins has a successful, highly disciplined approach that has paid off well for the fund.

The author, a fee-only certified financial planner (CFP), is president of L.J. Altfest & Co. ( http://www.altfest.com), a financial planning and investment management firm in New York City, and an associate professor of finance at Pace University. The ideas expressed in this column are his alone, and do not represent the views of Medical Economics. This column appears every other issue. If you have a comment, or a topic you'd like to see covered here, please submit it to Investment Consult, Medical Economics, 123 Tice Blvd., Woodcliff Lake, NJ 07677-7664. You may also fax your question to 201-690-5420 or e-mail it to meinvestment@advanstar.com
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