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Why Index Funds Are Best for Small-Business Execs
They deliver the most return for the least amount of time

An entrepreneur should hate index funds. They're boring, unsexy, unoriginal, and passive. They're run on autopilot by hands-off managers. Instead of making decisions about the best course of action, the managers merely try to match the overall market's performance. They strive to be average.

In short, these funds are nothing like an entrepreneur -- which is exactly why entrepreneurs should make index funds their core holding. An investing strategy built on index funds is likely to bring higher returns than chasing after the best actively managed mutual fund -- and to leave you more time for building the value of your business. In other words, you'll be richer on both counts.

First, a brief definition. The traditional mutual fund is actively managed by a portfolio manager or team. They buy and sell stock frequently in attempts to "beat the market," usually defined by a broad measure such as the Standard & Poor's 500 index. Index funds are passively managed. Their managers buy and hold only the stocks contained in their chosen benchmark. Their aim is to mimic returns, whether the market goes up or down. They sell only when an investor wants to cash out. Naturally, this saves money on expensive research, salaries, and other overhead, and it avoids the emotional traps of buying at the top and selling at the bottom that afflict active managers. It also keeps your tax bill low by cutting down on capital gains. In theory, this all leads to higher returns. The big name in the field is Vanguard's Index 500 fund, which tracks the S&P 500 and now boasts about $60 billion in assets.

Which kind is better for small-business execs? Let's look at the odds. There are more than 10,000 funds of all stripes that are tracked by Morningstar Inc., the mutual fund industry's bible. We dug into its database and screened all the specialty and sector funds, since it's too risky to put the bulk of your holdings into one industry. For the remainder, we calculated the returns to account for sales commissions -- or loads -- and then compared them to the Vanguard Index 500 fund for the past 5- and 10-year periods.

The result: Just nine actively managed funds beat the index fund. That's hardly an inspiring record -- your chances of picking the right ones are remote at best. And it's especially hard to justify the effort when you consider how little work it takes to pick an index fund that delivers almost the same return. Although you certainly won't beat "the market," you'll beat almost everyone else you know who spends hours sweating over their mutual-fund choices.

RETURN ON INVESTMENT. The second major point in favor of index funds: They save time -- something that's in perennially short supply for small-business owners.

Think of it in terms of return on investment. Business brokers say an entrepreneur who buys a company should expect to make 20% to 40% on his or her money annually, if things go right. By contrast, the returns from mutual funds in the past three years, during a booming stock market, barely approached that range. Historically, the stock market's normal return is closer to 11%. So if building your business is likely to produce a return that's twice as large, it makes no sense to spend extra time scrabbling to find the next hot mutual fund for a mere percentage point or two.

Finally, index funds provide the diversity a small-business owner needs. As we've pointed out, a small-business owner should have a balanced portfolio that takes into account the fact that your single biggest asset is a small, relatively illiquid company that concentrates you in one industry. Most index funds, by contrast, give you a healthy dollop of large companies that represent many industries, and the shares of these funds are easily bought and sold.

What about the idea that actively managed funds are safer than index funds in a downturn? There's little support for that idea, based on the most recent downturn. Early data from Morningstar show that S&P 500 index funds dropped more than 10% in the third quarter, but the average actively managed fund fell even more -- 11.69%.

Which index fund should you pick? Vanguard is the granddaddy in this business, and its S&P 500 fund is the flagship. The main reason Vanguard does so well is that its annual expenses are among the lowest in the industry -- 0.19% of your assets annually. (At the typical actively managed fund, annual expenses are about 1.5% a year.) It also offers a broad array of other index funds, including a Total Stock Market fund that tracks the Wilshire 5000 index.

OVERALL EXPENSES. Recently, competing fund groups Fidelity and USAA have moved in to match Vanguard's low expenses. But just because some company offers an index fund doesn't mean it has mastered the art of keeping expenses low. For instance, expenses at T. Rowe Price Equity Index total 0.40%, but you're not getting any extra value. After all, they're merely trying to match the index. And you should never pay a sales charge on an index fund. This kind of fund is the definition of "no brainer," so you shouldn't be paying for advice.

How much of your assets belong in an index fund? That's where your financial planner can help. The answer varies depending on your age, financial status, and the health of your business. But you don't have to forgo active investing entirely if you have the itch to play with some of your portfolio. Gus Sauter, the head of indexing for Vanguard Group, says a conservative investor who has 50% of assets in bonds should consider putting 30% into equity index funds and 20% in actively managed stock funds. "With 30% in that core holding, you can tailor the rest of the portfolio to areas you think might pay off more," he says.

As we've noted, that's a difficult game to play. But if you can't resist -- and many risk-embracing entrepreneurs can't -- we'll try to give you some guidance on what to choose in our next column.

By Rick Green and Timothy Middleton in New York

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