Mutual funds face tough competition

Wall Street at times is so competitive that even the C-students can be hard to beat.

When the merely average — such as benchmarks like the Standard & Poor's 500 index and the Dow Jones industrial average — perform as well as they have recently, mutual funds that try to mimic but stay ahead of a major market indicator can be hard pressed to make a case for themselves.

So-called enhanced index funds try to do it by mirroring the investments of a particular index and then attempting to wring further gains by making side investments such as in stocks outside the index. Managers of enhanced index funds need to make smart calls if their funds are to appear attractive when compared with regular index funds.

Lately, major market indexes and the funds that track them have given investors reason to pay attention. On May 30 the S&P 500 broke a seven-year-old closing record, signaling the index of large U.S. companies had fully recovered from the dot-com flameout.

The resurgent S&P joins indicators such as the Russell 2000 index of smaller companies and the Dow industrials, which for months have been setting record closes. Many regular index funds are tied to the performance of these indexes, meaning many investors are seeing gains.

Joel Dickson, a principal at Vanguard Quantitative Equity Group, noted that many enhanced index funds, when looking for side investments, will turn to companies that are smaller than those of the rest of the fund. So a fund tracking the S&P 500 might invest in what is still a large company but smaller than most of those in that index. Their smaller size can bring opportunity for gains, he noted.

"One of the reasons that these types of strategies have become so popular in recent years is because they've performed well," he said.

Dickson said investors need to be aware that enhanced index funds may not have the generally low-fee characteristics of straight index funds. Fees for regular index funds are generally low because there is no stock-picking. And their performance includes an enhanced element of risk.