3 Ways to Use Index Funds

Consider using some form of indexing in your portfolio.

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Index funds and exchange-traded funds can be a wise addition to almost any type of portfolio, experts say, because they provide instant diversification and are generally cheap to own. Since they track indexes, these funds won't lead during a market rally, but they also won't fall as far as some actively managed funds during a downturn. "Index vehicles can be very useful for people who are really realistic about the amount of expertise and effort it requires to pick and monitor active managers," says Alice Lowenstein, director of managed portfolios at Litman/Gregory, an investment research firm. As more indexing options become available, investors may want to give them a second look. Here are three ways investors can incorporate indexing in their portfolios.

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Standalone investments. Small investors can theoretically create a diversified portfolio with just two or three index funds. For example, you might pair Vanguard Total Bond Market Index (symbol VBMFX), which covers the spectrum of U.S. investment-grade bonds and charges an annual fee of 0.22 percent, with an fund representing the entire U.S. stock market, such as Vanguard Total Stock Market Index (VTSMX), with an annual fee of 0.18 percent. Throw in an international fund, and you've got the world covered. Litman/Gregory recommends Vanguard FTSE All-World ex-US ETF (VEU), which levies an annual fee of 0.25 percent. "Instead of requiring that you do the research and select active managers and monitor them on an ongoing basis, you're really trading that effort for the relative certainty of a low-cost, broadly exposed investment vehicle," Lowenstein says.

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Tactical allocation. Lowenstein says investors can use index funds or ETFs in their portfolio to emphasize a sector that they believe is promising. "One of our ways that we seek to add value over time is by pursuing occasional, highly compelling opportunities to buy an undervalued asset class, and typically hold that for a shorter time frame of about three to five years," she says. Currently, Litman/Gregory recommends that its clients dedicate a slice of their total equity allocation to emerging markets with the Vanguard Emerging Markets ETF (VWO) because the firm believes the sector is poised for strong growth in the future. The International Monetary Fund projects that the emerging—or developing—economies will grow at a rate of 6.8 percent in 2010, versus 3.3 percent for the United States.

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Combined with active management. When using index funds, it's important to find out what's in the underlying benchmark. Take the Barclays Capital U.S. Aggregate Bond Index, which covers the U.S. investment-grade bond universe. Investors should be aware that a large part of that index is made up of government-backed securities like treasuries—and now may not be a good time to be heavily exposed to that sector, given how low yields are for some fixed-income investments. Lowenstein recommends that investors use a combination of index funds and actively managed funds. "One of our allocations right now is to fixed-income managers who have a lot of flexibility to navigate a likely changing environment of potentially higher rates and inflation concerns down the road," Lowenstein says. "So in those cases, we're using some active fixed-income funds even in the indexing portfolios." Funds she likes include Osterweis Strategic Income (OSTIX) and PIMCO Unconstrained Bond (PFIUX), both of which can invest in various sectors of the bond market that the managers find compelling.