Index Funds Lock In the Ups, But Also Any Downs Ahead

In the world of mutual funds, "average" is often a lot better than average.

Funds that simply mimic the broad stock market - buying the companies of the Standard & Poor's 500 stock index - started the new year with a bang.

The S&P 500 index has set the pace for stock investors for three years running. And it recently set a new record - closing above 1000 for the first time ever.

So it's not surprising that index funds are on a hot streak. Vanguard Index 500, the largest of these funds, is up about 4.3 percent this year, versus a 3 percent gain for the average US stock fund.

But don't rush out and deposit your paycheck in an index fund, analysts say. A reality check may be in order.

The whopping gains of recent years are unlikely to persist, given that stock prices are already high and corporate earnings face increasing pressure.

Wall Street analysts see a volatile year - where financial indexes rise one day and sink the next.

"Index funds don't necessarily get killed in a down market. But they will follow an index downward," says Russel Kinnel, who heads equity research at Morningstar, a financial information firm in Chicago.

"Any time you have such great returns as have occurred in recent years," you have to be wary, he says.

Index funds are designed to match the performance of a broad array of stocks or bonds in a specific index, such as the S&P 500. Thus, they are typically passive, having no intervention by a manager.

An index fund does not buy stocks in equal amounts. Right now, if you put $100 in an S&P 500 fund, about $3.14 will go to buy General Electric, the company with the largest stock-market value. Another $2 each will go into both Exxon and Microsoft, and only a few cents into the smallest stock in the index. The proportions change as these stocks fluctuate in share price.

Kinnel's warning about this year's risks is significant, because many people make an index fund their "core," or primary fund holding.

There's nothing wrong with that, if you are willing to overlook some sharp downs along the way to a long-term goal.

For the long haul

Index funds are best designed "for long periods of time," such as five years or more, Kinnel says.

If history is any guide, the downside risks eventually are rewarded by upside gains.

Say you invested $1,000 in the Vanguard Index 500 Fund 10 years ago. Your money would now be worth $5,000 (a 17.5 percent annual gain), compared with about $4,000 (15 percent a year) in the average US stock fund..

That's the argument in favor of index funds.

Short-term challenges

On the opposing side, some financial advisers say cautious investors might pare back on index holdings now.

"At some point, the market is going to drop," says Sheldon Jacobs, editor of the No-Load Fund Investor, Irvington-on-Hudson, N.Y.

And index funds will bear the full brunt of any downturn. An actively managed fund, by contrast, can sometimes cushion the fall by moving money into cash or relatively stable stocks.

The investors who can shift most easily in and out of index funds are those with tax-sheltered retirement accounts. There isn't any capital-gains tax penalty.

But timing your moves in and out of index funds, or stocks in general, is notoriously tricky. For a couple of years now, some experts have been calling for a bear market - a drop of 15 percent or more - that has yet to occur.

There are now some 172 index funds, with total assets of about $157 billion, according to Morningstar.

Which one to buy depends on which index you want to track. And rather than opening a new account, you may want to choose from funds that are available in your 401(k) retirement plan or from a single mutual-fund supermarket (such as Fidelity, Schwab, or Waterhouse).

Most index funds have low annual expenses, often 0.4 percent of assets, versus 1 percent or more for a managed fund. Vanguard is known as a low-cost leader.

More important than low expenses is flexibility, says David Bendix, a certified financial planner in Uniondale, N.Y. Make sure you can shift your money into another fund, such as a money-market account, with a quick phone call if you want to.