No matter how much you analyze and scrutinize, selecting a mutual fund is an uncertain proposition, observes Dow Theory Forecasts.
"In addition to the risk inherent in any bond or stock market, you must consider fund managers' security selection and market timing decisions. Lousy managers can lag in even the strongest years. In fact, more managers subtract value than add it. As a group, fund managers have consistently underperformed the market indexes. Over the last decade, for example, the Standard & Poor's 500 has gained an average 15.1 percent annually, while the average domestic stock fund has gained just 12.8 percent."Of course, many superior funds regularly outperform the indexes. But there's no guarantee they'll go on doing so. If you really want to eliminate the risk of manager underperformance, says Dow Theory Forecasts, there's only one option: "Buy an index fund."
Index funds attempt to replicate the performance of a particular market index, such as the S&P 500. Today's index funds mirror everything from the small-company Russell 2000 to the Lehman Brothers Aggregate Bond Index to the Edison Electric Institute Index. Some hold futures contracts in lieu of stocks and bonds. Others attempt to outperform an index without straying too far from its basic design.
Index funds have several advantages, says DTF.
"True index funds have no research costs and low portfolio turnover, so expenses are low. For example, the Vanguard Index Trust 500, the biggest and probably the best fund for individuals who want to mimic the S&P 500, has had an expense ratio of around 0.2 percent since 1988. Minus these negligible expenses, the fund has moved in lockstep with the S&P 500."
The other major advantage of an index fund is more certain returns, says DTF. Of course, certainty of returns comes at a price: the knowledge that your index fund won't outperform its index. To remedy this drawback, there are index-plus funds, which use active management to enhance an index-like portfolio.
If you do decide to index, DTF advises against limiting yourself to the S&P 500. Here are some of its favorite index funds:
Vanguard Index Trust 500: replicates S&P 500
Vanguard Quantitative: attempts to outperform S&P 500
Fidelity Disciplined Equity: attempts to outperform S&P 500
People's S&P Midcap Index: replicates an index of medium-sized companies
Vanguard Index Total Stock Market: replicates Wilshire 5000, which includes active stocks on the NYSE, ASE or OTC markets
Vanguard Index Extended Market: replicates Wilshire 4500, the smallest companies in the Wilshire 5000
Vanguard Small Capitalization Stock: replicates Russell 2000, a sampling of small-firm stocks
Vanguard Balanced Index: 60 percent replicates Wilshire 5000, 40 percent replicates Salomon Brothers Broad Investment Grade Bond Index
Vanguard Bond Index Total Bond Market: replicates Lehman Brothers Aggregate Bond Index
Fidelity Diversified International: attempts to outperform the Morgan Stanley EAFE international index
Schwab International Index: replicates the world's 350 largest non-U.S. companies.
(Dow Theory Forecasts, 7412 Calumet Ave., Hammond, Ind. 46324; weekly, $233/year)