Mutual Fund Types Where Indexing Works Best

How to Get the Most Out of Index Funds

See which types of mutual funds are best for index investing. Getty Images

Without a doubt, index funds are the best overall investments in terms of average annualized returns over long periods of time.

The simple, low-cost structure of index funds helps these passively-managed funds produce superior returns compared to actively-managed funds. However, indexing has its strengths and weaknesses. This article will focus on the strengths.

But First a Word on Efficient Markets

The Efficient Markets Hypothesis (EMH) essentially says that all known information about investment securities, such as stocks, is already factored into the prices of those securities. Therefore no amount of analysis can give an investor an edge over other investors. EMH does not require that investors be rational; it says that individual investors will act randomly but, as a whole, the market is always "right." In simple terms, "efficient" implies "normal." For example, volatility (i.e. the ups and downs of the stock market) is a normal function of securities prices.

Index investing was born out of the idea of efficient markets. Proponents of EMH often invest in index funds because they are passively managed (these funds simply attempt to match, not beat, overall market returns).

When John Bogle founded Vanguard his eventual creation of the first index fund open to the general public, Vanguard 500 Index (VFINX), was based upon the idea that most investors will have greater long-term returns when simply buying an index fund, as opposed to picking their own stocks or buying an actively-managed mutual fund.

However, investment experts disagree on the efficiency of markets. And there is logic in why Bogle started with a large-cap index fund like VFINX.

Best Investment Types for Indexing

You don't need to be a statistics fan or math major to get why the virtues of indexing and the principles of EMH may not apply evenly across all investment types.

The basis of EMH is that investors cannot gain an edge over other investors if all the available information about investment securities is already priced into the securities. But some securities have more information available to the public than others. Therefore, the more is known about an investment type, the better the case for indexing.

  • Large-cap US Stock Funds: It's probably no coincidence that the first index fund available to the public, Vanguard 500 Index, invests in large US companies. Without inside information, all there is to know about a gigantic corporation like Wal-Mart Stores, Inc (WMT) is available in an instant on the Internet. A 5th grader can be taught within minutes how to look up and interpret the basics of Wal-Mart's financial statements. But what about a much smaller retail firm that has no national presence? An investor willing to do some research can possibly buy the next Wal-Mart before the crowd jumps on it or even before most have even heard of the company.
  • Large-cap European Stock Funds: For similar reasons as US large-cap equities, the European counterparts are highly efficient and work well with index funds. Asia and emerging markets have less available information and are thus more of an uncertainty with long-term indexing qualities. The managers of European stock funds tend to have similar holdings and the various European nations are often affected by similar economic factors. In addition, many actively-managed international stock funds investing in Europe have high expense ratios, which makes their index counterparts even more attractive, boosting performance potential over time. With regard to these higher expenses, John Bogle, in his book, Common Sense on Mutual Funds: New Imperatives for the Intelligent Investor, he says "the annual handicap to be overcome may approach 4 percent, nearly double the plus-2 percent handicap faced by U.S. equity managers. At this cost level, it is virtually impossible for most managers to provide superior net returns."
  • Core Aggregate Bond Index Funds: The EMH theme continues here with bonds. The prices for bonds fluctuate for similar reasons as stocks in that the prevailing economic conditions, and the near-term future expectations of interest rate policies, will affect all securities similarly. However, some bonds and bond funds have higher interest-rate sensitivity and could possibly benefit from actively-managed strategies. However, the overall bond market indexes are heavily weighted to high credit quality US Treasury bonds and corporate bonds, which are issued by large entities with high accounting transparency. Therefore most investors can satisfy their need for bond funds in a portfolio with a good index bond fund.

    See Also: Best Fund Types for Active Management

    Disclaimer: The information on this site is provided for discussion purposes only, and should not be misconstrued as investment advice. Under no circumstances does this information represent a recommendation to buy or sell securities.