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Investors should look at index funds

What is one of the best ways to boost your investment return?

A new paper suggests that in both up and down markets, investors are likely better off with low-cost funds that simply track a diversified benchmark of stocks or bonds.

The paper, by the Vanguard Group, was previously released but updated recently to reflect returns through the end of 2013, a banner year for U.S. stocks.

And the data show that index funds more often than not beat the performance of funds with a manager who actively chooses which investments to buy and sell in a fund.

For example, last year, well over half of actively managed funds that owned stocks of large U.S. companies trailed the performance of the average index fund in the same category.

The numbers did not improve over longer periods, especially when funds that were closed or merged with other funds were considered.

Why do index funds have the edge?

Low expenses are one reason.

The average actively managed fund that invests in U.S. stocks charges 1.26 percent in annual fees, Morningstar said.

Meanwhile, the average U.S. stock-holding index fund costs just 0.73 percent, and many index funds charge fees significantly lower than that.

The difference in price can have a big effect on your earnings.

Consider, for a moment, that both an actively managed and index fund achieve an average return of 7 percent annually over 30 years.

When you account for expenses, an investment of $10,000 in an actively managed fund would grow to $53,400.

But if you had invested in an index fund, you would have done even better, topping out at $62,000, because of the lower fees.

Of course, actively managed funds aim to deliver better returns than their index-tracking peers. If the funds are successful, you could end up with a bigger pot of savings.

But as the Vanguard study showed, investment pros have a hard time consistently beating the market.

For example, only 12 percent of actively managed U.S. stock funds that were in the top 20 percent of their category for five-year returns through the end of 2008 managed to stay in that same ranking for the next five years.

Vanguard introduced the first index fund in the 1970s and remains a leading provider of the funds, so the company may have a natural bias. But other research has shown similar results, and many financial planners talk up the virtues of index funds too.

For young investors, the funds are an especially good way to get low-cost diversified exposure to stocks and bonds.

“They are a great strategy,” said Chris Long, a financial planner in Chicago.

You may be able to find an index fund in your 401(k) or other retirement plan offered by your employer.

According to the Plan Sponsor Council of America, 80 percent of 401(k) plans offer U.S stock index funds, and 41 percent of plans have a U.S. bond index fund.

If not, index funds are easy to buy on your own, Long said. Investment firms such as Fidelity, Schwab and Vanguard all offer the funds.

Vanguard has target-date retirement funds that own a mix of stock and bond index funds appropriate for your age. Fidelity does as well, but the funds are available only through workplace retirement plans.

“These are a good option for young investors in the earlier years of investing,” Long said. To get started, the minimum investment is just $1,000.