I don't understand why some index funds outperform their index. Isn't the whole point to mimic the index?

QUESTION: With only a vague concept of what index funds were about, I took a look at some of them and came away a bit dismayed. I don't understand why some funds "outperform" their index. I thought the whole object was to mimic the index. Can you clue me in?

-- Jaki Evans  
ANSWER:

Think about it. For starters, fund managers must buy and sell stocks whenever changes are made to the index they track. Just this month, for example, Univision Communications (UVN) was added to the S&P 500, while Union Carbide, which recently merged with Dow Chemical (DOW), was dropped. A fund manager strives to do all of his or her buying and selling on the day of the change. But even so, intraday moves in the securities' prices can often affect returns. Additionally, fund managers must cope with a growing or shrinking investment pool, as shareholders add or withdraw money from their accounts. When an index is hot -- like the S&P 500 was during the late 1990s -- money rushes into these funds and fund managers have to put it to work. But when the index cools, some investors inevitably pull money out, forcing a manager to sell shares. Both circumstances can be disruptive and could affect the fund's return.

John Demming, spokesman for Vanguard Group (the granddaddy of indexing), goes so far as to say that there's an art to managing one of these funds. Vanguard offers 29 index funds including the largest -- the $100 billion Vanguard 500 Index fund (VFINX). George Sauter, who manages Vanguard 500, uses computer models to oversee the trading process, which sometimes cause the fund to outpace the index by a few fractions of a percent and sometimes cause it to trail. On a three-year annualized basis, the fund has returned 12.30%, slightly more than the S&P's 12.26% return. But on a five-year annualized basis, the portfolio has returned 18.31%, a bit below the index's 18.33% gain.

Generally speaking, as long as an index fund's returns aren't completely out of whack with the index it follows, you shouldn't be alarmed by variations, says Marcee Yager, a certified financial planner with San Jose, Calif.-based Sterling Wood Financial. That said, you should look out for index funds whose returns regularly fall below their index. Sometimes this is due to poor trading techniques, but more commonly a fund's returns suffer because of fat expense ratios, since expenses are subtracted from returns. A fund like Vanguard 500, which has a minimal 0.18% expense ratio, doesn't need to overcompensate by much to match (or beat) its index. But then there's the MainStay Equity Index fund (MCSEX), with its 0.94% expense ratio. Last year it fell 9.83% vs. the S&P 500's loss of 9.10%.

Keep in mind, there are some funds that actively aim to outdistance their respective indexes. With names such as "enhanced" or "plus" index funds, their strategy is to invest only in the stocks held in a particular index that the manager believes have the best growth prospects. Yager says these funds offer marginal gains, so you'd be better off seeking low-expense funds. Heading up the risk curve are so-called leveraged index funds, like those offered by ProFunds. They use index futures and options to outpace their respective indexes. As you might expect, if the index tumbles then these funds will fall even farther, since they try to outpace the index, even if it's heading in a negative direction.