Index funds tell the tale of 2013’s winners

Many of life's rules are unchanging. Don't make toast in the bathtub. Let sleeping bears lie. Not one of your Facebook friends cares what you had for lunch.

But many financial rules change, and often not in a good way. For example, investing in an index fund is a fine idea. This was swell advice when there were only a few index funds.

Thanks to the ever-increasing need of the fund industry to attract new money, however, you now have hundreds of index funds from which to choose. Some of them are good. Some of them are awful. But it's no longer an easy decision, as you'll soon discover from third-quarter results.

Index funds dump the manager and instead follow an index, such as the Standard & Poor's 500, a large-company stock index, or the Russell 2000, a measure of small-company stock performance. Following an index has three distinct advantages:

• They eliminate the manager, who can be wrong as often as he is right.

• They have much lower fees than actively managed funds, which can be an enormous advantage over the long term.

• They tend to have fewer and smaller capital gains distributions than actively managed funds, which boosts your after-tax performance.

The classic example is the Vanguard 500 Index fund, which has beaten 65% of funds in Morningstar's large-company blend category over the past decade — all at a cost of 0.17% a year, or $1.70 for every $1,000 managed.

From an investment management perspective, however, running an S&P 500 index fund has some severe drawbacks. The product has no discernable difference from fund company to fund company except expenses, with lower being better. (Despite this, a few fund companies have managed to produce truly awful S&P 500 funds, such as the Rydex S&P 500 C shares, which charges an astounding 2.3% a year in expenses. It's like buying salt for $60 an ounce.)

Rather than try to create a high-priced commodity product, however, many fund companies simply tried to create index funds! with a twist. The worst are the leveraged funds, which use futures and options to give you twice the gain and twice the pain of a traditional fund. These not only tend to be more expensive than traditional index funds, but far riskier.

Not to pick on Rydex — OK, we're picking on Rydex — but consider the Rydex Inverse S&P 500 2x Strategy fund, which charges a mind-melting 2.51% expense ratio, according to Morningstar, the Chicago investment trackers. When the S&P 500 rises 1% in a day, the fund is designed to fall 2%, and vice versa. The fund is down 28.6% this year.

Is it possible this fund could be useful to the average investor? Yes. It's also possible to be strangled by an orangutan. It's just not likely. And it's far more likely that the average person could use this fund at the wrong time — and, by trying to avoid a loss, pay a high price for making the wrong call.

Other bad index funds include this year's likely top performer, the Direxion Daily Gold Miners Bear 3X shares, which pledges to fall 3% every day an index of gold mining stocks rises 1%. The fund is up 106.1% this year, because gold mining, a dicey occupation at best, is an awful business when the price of gold is falling. You need this fund like you need mice.

Are there any index funds — aside from the plain vanilla ones mentioned earlier — that are worth investigating? Actually, there are.

• Equal-weighted funds. The S&P 500 is weighted by market capitalization, which is a stock's share price multiplied by the number of shares outstanding. By that measure, Apple is the largest stock in the universe, and it gets 2.54% of the Vanguard 500 Index fund's assets. By the same measure, Boeing gets 0.43% of the fund's assets. An equal-weighted fund puts the same amount of assets into each of the index's components.

A fund that's weighted by market cap tends to do best in a concentrated market — that is, when one stock or group of stocks excels. The Guggenheim Investments S&P 500! Equal We! ighted ETF (ticker: RSP) has gained 24.3% this year, outpacing the cap-weighted S&P 500. The main reason could well be Apple, which has lost 6.8% this year, including reinvested dividends.

Equal-weighting makes more sense for funds that follow the Nasdaq 100 stock index: Apple accounts for 12.1% of the popular PowerShares QQQ fund, up 21.3% this year. The Direxion Nadaq 100 Equal Weighted Index shares (QQQE) has gained 29.1%.

• Value and growth indexes. A value manager looks for beaten-up stocks that Wall Street hates, and waits for them to reach normal value. A growth manager looks for stocks with rapid earnings growth, selling them when they disappoint.

Value stocks tend to pay more in dividends and suffer less in bear markets than growth funds do. Growth funds tend to soar in hot bull markets. This year, value has been the place to be: Guggenheim Investments S&P 500 Pure Value ETF (RPV) has gained 31.1% this year, while its companion, Guggenheim Investments S&P 500 Pure Growth ETF, has gained 28.9%.

• Cap-based indexes. Small-company stocks typically fare better than larger ones, because they have more room to grow. This year was no exception: The iShares Russell 2000 ETF (IWO) soared 27.6% this year, and the iShares Russell 2000 Growth ETF (IWZ) jumped 32.1%.

• Buyback and dividend indexes. The Schwab U.S. Dividend Equity ETF includes only stocks that have increased their dividends regularly: It's up 22.2%. The PowerShares Buyback Achievers fund (PKW) invests in companies that actually buy back their stock and reduce the number of shares outstanding — which, in theory, should make remaining shares more valuable. The fund is up 32.2% this year.

For most investors, your basic aim should be getting exposure to stocks at a low cost, and broadly based index funds are the best bet. You could cover the world with the iShares MSCI World ETF (URTH, up 18%) for just 0.24% a year in expenses, or $2.40 per $1,000 invested. Tough to argue with that. If you ! do use mo! re exotic indexes, remember that their above-average performance may someday come with above-average risk.