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The Pros and Cons of Index Funds

- Alan Lavine and Gail Liberman

Although index mutual funds typically outperform actively managed funds, actively managed funds quietly have taken a lead over index funds over the last eight years.

It's especially nice to have a fund manager if there's a bear market, many of us learned the hard way in the bear market of 2000. After all, index funds have no manager to bail you out when the market sinks.But could it be time to toss your index fund? Not necessarily.

Index funds have some good things going for them. Chief among them: They typically are low-cost. Their expenses run under one-half-of-one percent annually. By contrast, the average mutual fund annual expenses run 1.4 percent, according to Morningstar Inc., Chicago.

Over the past 25 years, the S&P 500 has outperformed the majority of actively managed funds, according to Morningstar. This bodes well for index funds that track that particular published index.And even though you get no manager with an index fund, there's nothing to stop you from diversifying index funds on your own. This way, you can create a low-cost mix of funds. You can select from large, medium and small company stock index funds that invest based on growth or value. There also are international index funds.

Plus, there have been more bull markets than bear markets--a favorable scenario for stock index funds.

But recent financial research by Sung-Jun-Woo, finance professor at Harvard University, found that a fund manager that has a good long term track record also should continue to perform well in years to come.

In addition, fund managers can take steps to change their investments as economic and financial conditions change. If the stock market is heading south for an extended period, a fund manager may put money in cash as a safe haven. Other managers may use the pull back in the stock market as an opportunity to buy attractively priced stocks.By contrast, index funds remain fully invested.

If you do opt for an actively managed fund, be sure to:

  • Check the fund's year-by-year returns. You want to invest in low-cost funds that have consistent returns.

  • Examine how the fund performed in both up and down markets.

  • See how the fund performed compared with similar funds and the market average during the 2000 to 2002 bear market. Evaluate the performance since.

    There are a number of well-managed mutual funds. Funds with excellent long-term track records are offered by fund groups, such as Fidelity Investments, T. Rowe Price, Legg Mason and Oakmark to name a few.

    The screener at www.morningstar.com can help you find the actively managed funds with the best long-term track records.


    Spouses Gail Liberman and Alan Lavine are syndicated columnists. Their latest book is "Rags to Retirement (Alpha Books)." You can e-mail them at MWliblav@aol.com.

    To read more columns, please visit the column archive.

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