Is the Index Fund Dead?

It’s heresy to academics, and we can already hear the howls of protest at the very suggestion. But the stock market’s crash does beg the question: Is it time to move beyond the vanilla index fund?

With their rock-bottom fees and tax efficiency, index funds are tough to beat over the long run. Advisers often recommend them as the lowest-cost way to get into the market, and mutual funds typically rely on the major indexes for gauging their own performance. But the academic merits of sticking your money in an S&P 500 fund may be cold comfort if you’re down more than 40 percent over the past decade. Low fees may be great but aren’t much consolation if your retirement is in jeopardy, says James Holtzman, a financial adviser with Legend Financial Advisors in Pittsburgh. And in a bear market, other types of funds, with more flexible strategies, may do a better job of preserving capital—and even posting gains.

Whether to go with an actively managed or an index fund is, of course, a long-running debate. If you have a 30-year horizon, chances are your index fund will ultimately win the race, as fees and taxes drag down returns of the active funds, says Lipper research manager Tom Roseen. And when stocks have extreme up or down years (such as the rapid 41 percent drop we saw in a few weeks last fall), the indexers tend to win. But now is exactly the time many experts say active management can shine. If markets bounce along the bottom (as many strategists think we’ll see this year), active managers could have an edge. Roseen says that’s because they can pare back on certain troubled sectors (think financials) and “make the appropriate bets.” They can also make swifter, more timely calls to take advantage of any mini-bull runs. Since the crash, the average actively managed fund is neck and neck with the average S&P 500 fund, according to Lipper. In six of the past 10 years, more than half the actively managed funds have beaten their index.

Many actively managed funds, however, are index funds in disguise. In other words, managers are expected to hew fairly closely to the amount one sector has relative to an index. For instance, if 17 percent of the S&P 500 is in financial stocks, some funds are limited to holding at least, say, 12 percent in financial stocks. Other actively managed funds are limited to a certain strategy—big companies with low stock valuations, for example.

Flexible strategy funds, though, have no such restrictions. They can roam broadly among different types of stocks, use hedging techniques in bear markets and shift into bonds, commodities or other asset classes that may offer higher returns. “They have more tools to play with,” says Morningstar analyst John Coumarianos, “so they always have something to do.”

A risk-averse attitude helps too. Michael Orkin, head of the Caldwell & Orkin Market Opportunity fund, can bet against the market or move into cash if stocks look unappealing. Last year he lost just 4.7 percent. “Our goal is to minimize losses,” he says, “and then we try to make money.”

The Mutual Discovery fund goes wherever it sees value. Comanager Anne Gudefin is currently looking for distressed firms with “good business models and bad balance sheets.” The Greenspring fund, meanwhile, has shifted primarily into bonds and convertible debt, and now has less than a third of its portfolio in stocks. The fund could lag if stocks take off, says Coumarianos. But on the whole, he says, it’s “a sleepy fund with a good, long record” that could help investors sleep better too.

In erratic markets, funds with the flexibility to bet against stocks or invest in alternative assets can help buffer against losses while still taking advantage of the good days.

Caldwell & Orkin Market Opportunity (COAGX)
One-Year Return: –0.4 percent
Five-Year Return: 7 percent
Expense Ratio: 1 percent
Manager Michael Orkin has the flexibility to go “short,” betting stock prices will fall, and is now using the 1930s as his investing paradigm—seeing more pain in the markets. Depressing? Yes. But Orkin spotted bubbles
in the housing and financial markets earlier than most other pros, and he’s up a cumulative 57 percent since 2000.

Mutual Discovery (MDISX)
One-Year Return: –23 percent
Five-Year Return: 5 percent
Expense Ratio: 1 percent
This wide-ranging fund incorporates a lot into its strategy, including U.S. stocks, foreign “sovereign debt” and merger arbitrage, making money by buying and shorting the stocks involved in a takeover. Comanager Anne Gudefin is now preserving capital, with nearly 60 percent in cash—a high level for an actively managed fund. Still, Gudefin’s prudence has paid off, says Morningstar analyst John Coumarianos. Discovery’s five-year returns surpassed 99 percent of other funds in its category.

Greenspring Fund (GRSPX)
One-Year Return: –16 percent
Five-Year Return: 2 percent
Expense Ratio: 1 percent
Manager Charles Carlson runs a balanced fund, but he shifted assets into cash and fixed-income securities last year and now has less than a third in stocks. The fund could lag if stocks take off, but Carlson says he’s finding “good values” in the fixed-income world, which is “more predictable” than stocks. His five-year returns don’t amount to much, but they still beat 98 percent of rivals.

Data: Morningstar