U.S. Markets open in 4 hrs 20 mins

5 Ways to Navigate the Index Fund Maze

Daniel Solin

As a proponent of passive or evidence-based investing, I am heartened by the growing number of people investing in index funds. According to a Morningstar article, "A Bull Market in Passive Investing," only 12 percent of U.S. open-end mutual fund and exchange-traded fund assets were invested in passively managed funds as of Nov. 1, 2003. That percentage has risen to 27 percent, and it continues to grow.

Unfortunately, making the decision to invest in index funds is only the beginning of the process toward intelligent and responsible investing. These tips can help you navigate the index fund maze:

1. Costs matter. The management fee charged by index funds (also called the "expense ratio") can vary considerably. According to a recent article in Reuters, the fees charged by some index funds are higher than those levied by comparable actively managed funds. Among the offenders are funds managed by Rydex Funds, State Farm and Federated Investors.

Just compare the 2.28 percent fee charged by the Rydex S&P 500 Fund to the 0.17 percent charged by the low-cost leader Vanguard for its comparable fund. Other low-cost index fund families include Charles Schwab and Fidelity.

Brokers have the incentive to sell high-cost index funds. These products are created to be sold, but not bought. Don't fall for the pitch.

2. Stick with diversified funds. When I wrote "The Smartest Investment Book You'll Ever Read," I recommended a portfolio of only three index funds, with different allocations depending on the risk profile of the investor. The funds were the Vanguard Total Stock Market Index Fund, the Vanguard Total International Stock Index Fund and the Vanguard Total Bond Market Index Fund. Each of these funds is broadly diversified, which mitigates volatility. For many investors, a portfolio consisting solely of these three funds, in an appropriate asset allocation, would be a vast improvement over their current portfolios of individual stocks, bonds and actively managed stock and bond funds.

Since 2006, Vanguard has introduced a Total World Stock Index Fund, which seeks to track the performance of the stocks of companies in developed and emerging markets around the world. If you want to reduce your portfolio from three index funds to two, you could substitute this fund for the Total Stock Market Index Fund and the Total International Stock Index Fund.

If you want to add foreign bonds to your portfolio, you could consider dividing your bonds between Vanguard's Total Bond Market Index Fund and the SPDR Barclays Capital Short-Term International Treasury Bond ETF.

3. Avoid leveraged funds. The purpose of evidence-based investing is to capture global market returns. Avoid investing in speculative funds that seek to achieve a multiple of the daily returns of an index. An example of this type of fund is the ProShares UltraPro S&P 500. This fund is highly leveraged and seeks to achieve a return three times higher than the daily return of the Standard & Poor's 500 index.

These are risky funds, suitable for speculators and not investors. They require active monitoring and are more risky than funds that aren't leveraged.

4. Avoid specialized funds. Fund families are excellent marketers. They are jumping on the index bandwagon by offering many versions of index funds. You can purchase funds limited to dividend-paying stocks, value stocks, gold stocks, technology and even biotechnology stocks. Bonds funds have also been segmented, and now include funds that track industrials and utilities, among many others.

Buying these specialized funds defeats the purpose of evidence-based investing. When you purchase a fund limited to a narrow segment of the market, you are betting on the outperformance of that segment. Wall Street is littered with the broken dreams of those investors who thought they could successfully engage in this activity.

Take a look at what happened in 2013. Did you or your broker predict that gold would be down more than 50 percent or that silver would drop 45 percent? If not, they were in good company. Many investment professionals were bullish on the prospects for gold.

Trying to predict outperforming countries is even more risky. Did your broker predict that the stock markets in Finland, Denmark, Japan, Ireland and China would have stellar returns in 2013?

Trying to pick outperforming sectors is akin to gambling. Avoid specialized funds and stick to broadly diversified stock and bond index funds.

5. Don't forget discipline. Just because you invest in an appropriate portfolio of index funds with low management fees doesn't mean your work is done. My colleague Carl Richards, director of investor education at BAM Alliance, recently noted the difference in returns of a broad-based index fund and the returns actually captured by investors. Richards calls this difference the "behavior gap." It refers to the tendency of investors to bounce in and out of funds in response to changing market conditions.

Other than rebalancing periodically, your investment in index funds should reflect a buy-and-hold strategy. There is scant evidence that anyone has the ability to predict the future direction of the markets.

Dan Solin is the director of investor advocacy for the BAM Alliance and a wealth advisor with Buckingham Asset Management. He is a New York Times best-selling author of the Smartest series of books. His next book, "The Smartest Sales Book You'll Ever Read," will be published March 3, 2014.

More From US News & World Report