8 Index Funds With a Leading Edge

Whenever the stock market takes a turn for the worse, it reignites an age-old debate in the mutual fund world: Which strategy works better, active or passive management?

Fans of active management argue that it's well worth it to pay for the privilege of having a good manager that uses analysis to pick winning investments. However, passive investors reason the overwhelming majority of those managers inevitably underperform a given index over time. These investors simply put their cash in a low-cost index fund that tracks the returns of a benchmark like the S&P 500. The downturn just exacerbates this debate: The average S&P 500 index fund is down 4.4% in 2009, according to Lipper. Almost 40% of the large-cap funds and share classes in our database failed to beat that return. The average large-cap fund also trailed the S&P 500 in 2008. That means index funds seem to have the upper hand — at least for now.

With that in mind, we decided to focus this week's screen on index offerings. This is a much more elaborate undertaking than it appears. We don't simply look at S&P 500 funds since the only thing differentiating them would be the fees that eat into their performance. So instead of weeding out funds based on our regular set of criteria, this week we list a range of index funds and their performance numbers. The surprising revelation: Index funds with exposure to tech and small caps are beating their actively-managed competitors — and the S&P 500, too. See the table below for our eight picks.

There are a few reasons we resort to compiling the screen this way. Over the last few years the exchange-traded fund industry has pushed the boundaries of what constitutes an index fund. The gold standard used to be the S&P 500, but now investors can find funds based on indexes from Russell, Morningstar and Dow Jones and others that track the Nasdaq or use a new-fangled "fundamental" indexing strategy that focuses on book value and sales, among other things. There are even offerings that equal weight the S&P and concentrate on dividends.

While there may not be a huge difference between these funds' performances, even the slightest edge can add up since index investors usually hold their funds for decades. Just 1% more a year can mean tens of thousands of dollars over the life of a retirement account.

There are certain trends worth picking up on in the index world that professional money managers and individual investors alike can follow. Technology stocks, for example, typically perform well coming out of downturns because investors rush to the few shares still experiencing growth. That theme is playing out now. The tech-heavy PowerShares QQQ (QQQQ), or Cubes, which tracks the 100 largest non-financial stocks on the Nasdaq, is up 10.9% this year thanks, in part, to merger and acquisitions and some decent earnings.

Like tech stocks, small caps excel in times like these as capital becomes more accessible and M&A deals pick up. As a testament to this trend, funds that have exposure to small-cap stocks are outperforming the S&P 500. "The 29% small-cap gain since March 9 has been swift," said Citigroup's small-cap strategist Lori Calvasina in a recent report. "But it is short of the average 12-month bounce off market bottoms in recent recessions and crises." In other words, more upside could be had.

The Fidelity Spartan Total Market (FSTMX), an index fund that tracks over 3,000 stocks, has almost 30% of its holdings in small- and mid-cap stocks. Year-to-date it's down 3.6%, almost a full percentage point ahead of the S&P. The Rydex S&P Equal Weight index fund (RSP) assigns the same 0.2% weighting to each of the member companies in that benchmark (the usual methodology focuses on market capitalization). The subtle differences in weightings means the smaller companies in the S&P get equal billing. It has gained 0.8% in 2009.

Those index funds could easily lose favor to traditional S&P funds or actively-managed offerings if the market recovers. In fact, that already appears to be happening. The Dow Jones Industrial Average recently posted its fifth-straight week in the black. And as government rescue plans take hold they could put the financial sector, the one main drag on the S&P 500, back on the road to recovery. Indeed, Wells Fargo (WFC) announced on Thursday it will probably post record quarterly results later this month. Any rally could spark interest in the market's biggest blue chips, stealing small cap's thunder.

A rally could also play into the hands of active managers. We've watched over the last few months as managers like CGM's Ken Heebner have shuffled their holdings in funds like CGM Focus (CGMFX). They bought what they believed were cheap stocks and now are just waiting for the market to come around. If they start to post big numbers, the debate will quickly shift back to the merits of paying for a manager.

The Criteria: Below we list eight index funds along with their return numbers for different time periods. Some are traditional mutual funds. Some are exchange-traded funds. The funds listed below are not be construed as the best of their respective category. Indeed, we simply use one to represent the performance of its group as a whole (although, in some cases, fees will certainly play a part).