Wall Street’s Dirty Little Secret: The Bear Will Eat Your Index Fund

For years, financial advisor Suze Orman has preached that people should invest in index funds because most mutual fund managers don’t beat the market. (She’s correct.)

In 2005 she said:

“If you truly want a one-fund solution, I would recommend investing in a “total” stock market index or an “extended” market index. These funds own an even wider array of stocks than the S&P 500, which is focused on large established companies. The broader total and extended market indexes also hold mid-size and small stocks; it’s a great way to get exposure to all strata of the U.S. market.”

But recently, Suze Orman has changed her mind about what you should be investing in.

Now, she says, index funds are “out.”

You should be actively managing your own money. From June’s Money Magazine:

Q. You used to be a big fan of index funds. Now you’re not.

A. I know, I know. I’m switching for the first time in my life. All the stats say that index funds outperform 80% of managed funds out there. And a few years ago I’d have said just buy Vanguard’s S&P 500 index fund or its Total Stock Market index fund.

But today I think you have to be more active, and I like exchange-traded funds that let you own particular sectors, like iShares MSCI Emerging Markets, United States Oil Fund or the Metals & Mining SPDR.

Q. Oil and mining? You obviously aren’t worried that commodities are the next bubble.

A. No. I think it’s absolutely possible you could see oil go to $150 or $160. I’d never tell you to put 100% of your money into anything. But I think in this economy you need to manage your money more actively.

Suze Orman is admitting Wall Street’s dirty little secret: in bear markets, index funds don’t work.

If you invested $1000 into the S&P 500 index in March 2000, when the NASDAQ was peaking, by April 2007, it would have been worth less than $1000 (all dividends reinvested.) You would have lost money in those seven years.

And your return isn’t that much better if you continued to hold it until 2008.

The SPY (the S&P 500 Index) is down 9.32% through May 31, 2008.

Its one year performance is down 5.28%.

Over the last three years, you actually gained 5.73% a year. Not awful, but not stellar either.

No wonder most investors keep saying, “you can’t make money in the market.”

It certainly seems that way- if you’re in the index funds.

That’s why Suze Orman is saying to get out of the broad indexes. In a bear market, only certain sectors will outperform. In order to get larger returns, an investor has to figure out what those are and invest more strategically in those sectors.

That’s why stock picking becomes key in bear markets. Because, as Jim Cramer always says, there is always a bull market somewhere!

Heed Suze Orman’s advice: invest some money in specific sectors- instead of the broad market. In bear markets, indexes get mauled, but your portfolio doesn’t have to.