Index funds may provide 'average' returns

Many investors see no shame in being average.

That is why more than $548 billion is invested in 287 index mutual funds, according to Lipper Inc. These funds seek to mirror the performance of a given stock or bond index. Nothing more, nothing less.

Building a personal portfolio of index funds can be easy or complicated. You can own two or three broad-based funds, or get fancy, owning up to a dozen that track regions or specific investment styles.

This passive investment strategy began 36 years ago when Wells Fargo launched the first equal-weighted New York Stock Exchange portfolio for the Samsonite pension plan. The Standard & Poor's 500 index led the march of index funds to prominence.

Born 31 years ago, the Vanguard 500 Index (VFINX) has grown to $129 billion in assets and has a three-year annualized return of 10 percent. That performance places it at the midpoint among all large growth and value funds. It requires a $3,000 minimum initial investment and has a low 0.18 percent annual expense ratio.

Another giant, Fidelity Spartan 500 Index Fund (FSMKX), has $18 billion in assets and a 10 percent three-year annualized return. Requiring a $10,000 minimum initial investment, it has a modest annual expense ratio of 0.10 percent.

"For some investors, average looks darn good," said Jeff Tjornehoj, senior research analyst with Lipper in Denver. "More than a few people have looked back at active management of their stocks and bonds and said, 'Gee, I wasted the past 10 years on all those things people told me were hot."'

An upside of index funds is that studies indicate over time they outperform 75 percent of active portfolio managers. A downside is that every index fund holds some stocks or bonds even when they're suffering or failing, without the ability to dump them. It also can't increase holdings in up-and-coming stocks.

Index funds hold all the securities in the index, unless the index size or regulatory restrictions preclude that, and they must construct a portfolio approximating characteristics of the index.

Two or three basic index funds can provide a solid investment foundation for an individual investor.

"We are a big believer in having the broadest view in terms of diversification," said Fran Kinniry, principal with Vanguard Group's Investment Counseling and Research Group in Wayne, Pa. "With three index funds — a total U.S. equity fund, a total international fund and a total bond fund — you basically own all of the publicly traded companies."