Indexing: For Winners Only

TIRED OF FEELING LIKE A LOSER? FRUSTRATED BY YOUR low returns from mutual funds you thought were hot? Maybe you're ripe for a grown-up investment: a plain vanilla index fund. Favored by professional investors, these funds have been so little praised that amateurs tend to pass them by. But the secret to wealth is that a secret doesn't exist. For success you need only a simple investment with profits compounded over time.

This insight isn't easy to accept. Every month, in the personal-finance magazines, you're seduced by the promise of Funds to Buy Now!, each of them managed by a Croesus. But in money as in life, the wiser you get, the more guff you can blow away.

The truth about funds on the Top Ten lists is that most of them won't do as well as the major market indexes (an index, such as Standard & Poor's 500-stock average, measures general market performance). Their high-paid managers face two almost insuperable tasks. They have to pick stocks that go up in price by more than other investors expect which may not be doable in a world where so many players know so much. They also have to cover their costs: say, 1.5 percent in annual expenses and, for some funds, sales loads. Of 462 stock funds with 10-year records, fewer than one out of four beat the S&P 500 over the past decade, adjusted for upfront sales charges, according to Investability in Louisville, Ky. When you buy most funds, you are paying the manager to miss.

Indexers, on the other hand, think the key to success is to be the market. These funds own the securities (or a selection of the securities) that are used to compute a selected market index. They buy more of t shares as new money comes in, but sell only to meet redemptions or adjust to an index change. When you invest, you expect to match that market's performance, minus costs. Most equity funds track the S&P 500, a proxy for the large, dividend-paying corporations whose stocks are classified in the growth-and income group. Some reasons to try them:

They're easy. You can buy generic stocks" or "bonds" without bruising your brain over all the nuanced types of funds in Wall Street's souks. Indexers offer choices, too, but most are straightforward: generic international, small company or emerging-market stocks.

They're usually cheap. Some indexers charge high annual fees and even upfront sales loads. But it's pointless to buy them, says Cebra Graves of Morningstar in Chicago, a firm that follows fund performance. The highest returns should come from the funds with the lowest costs, which leads you to the Vanguard Group in Valley Forge, Pa. For its Vanguard 500 index fund, which tracks the S&P 500, you pay only 0.19 percent annually, and for its Total Bond Market fund, a mere 0.18 percent. Because of the higher cost of investing in specialty markets, Vanguard charges an upfront fee for index funds that buy small or foreign stocks other shareholders don't have to bear your setup expenses). Schwabs funds levy no such fee but sock you with heftier annual costs. Not-quite indexers like Principal Preservation S&P 100 Plus charge even more. Principal uses options to try to earn superior returns, yet can't seem to beat Vanguard's simple 500.

Their performance is fine when costs are low with the Vanguard 500 topping the chart. Among retail funds, it alone ranked in the top third of its group (growth-and-income funds) over the latest one-, three and five-year periods. In this year's first quarter, it spurted into the top 8 percent of all equity funds, because big stocks are doing unusually well, says Vanguard chairman John Bogle. When the market drops, index funds drop, too. But the faithful keep investing, knowing that stocks will rise again.

They save taxes. Index funds rarely sell stock, so there aren't big distributions of taxable capital gains.

They help you diversify. First choice might be an index fund for smaller stocks. The oldest fund in this, Vanguard's Small Cap, performed roughly as we as average of all small-stock funds in the past five years. So chance of finding a better fund is 50-50. Dartboard odds. As for international investing, doubters question whether it to into the other industrialized countries, Investors profited by tracking the EAFE index which covers the biggest stocks in Europe, Australasia and the Far East. But you made money only because the U.S. dollar declined, raising the value of holdings abroad. You'll find stronger returns elsewhere, says Rex Sinquefield, co-chair of Dimensional Fund Advisors, a manager of indexed institutional investments. His choices: international small stock funds or international "value" funds (for stocks with low market prices relative to their book value). Alas, these sectors aren't yet served by low-cost retail index funds.

If you still think you can beat the odds, take a look at the table on this page. Only eight growth-and-income funds recently bested the Vanguard 500. When I tested this list for performance through March and several other recent periods, only Mutual Shares survived. With odds like that, indexing seems a Solomonic choice.

Few retail investment managers can beat the Vanguard 500 index fund. Of 99 growth-and-income funds with 10-year records, only eight made the grade over the past 1, 3, 5 and 10 calendar years.

COMPOUND ANNUAL RETURN FUND FOR 10 YEARS SAFECO Equity 16.2% Dodge & Cox Stock 15.4 Mutual Beacon 15.4 Mutual Qualified 15.1 Mutual Shares 14.8 MAS Value* 14.7 FPA Paramount 14.4 Scudder Growth & Income 14.3 Vanguard 500 Portfolio 14.1 *SOLD THROUGH SCHWAB AND OTHERS. ADJUSTED FOR 6.5% SALES CHARGE; CLOSED TO NEW INVESTORS. SOURCE: INVESTABILITY

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