Q. Jeremy Siegel argues in his new book, "The Future for Investors," that index funds like the S&P 500 or the Wilshire 5000 don't perform as well as stocks with low price-earnings ratios and high dividends. Could you suggest a replacement index fund for the Vanguard Total Market Index fund in the Couch Potato portfolios that would have these characteristics? I know Vanguard has some value funds, but I'm not familiar with an index fund that selects for both low price earning ratios and high dividends.

-J.R., by e-mail from Dallas, TX

  

A. Professor Siegel has a good point--- index funds have their limitations. They are, however, much like democracy in a famous Winston Churchill quote---"Democracy is the worst form of government except for all those others that have been tried."

The recurrent embarrassing fact is that whatever the deficiencies of traditional capitalization weighted stock indices like the S&P 500 or the Wilshire 5000; they tend to provide better returns than 70 percent of their managed competitors over long periods of time. This is due to lower management expenses, lower turnover expenses, and greater tax efficiency. It would be foolish to give up an index fund to pursue managed value investing.

A great deal of research backs Professor Siegel's assertion that stocks with low price/earnings ratios and high dividends will do better than pure index funds. That's the well known conclusion of the Fama/French research. It's also the conclusion of well known investors like David Dreman (check his books) and Robert Rodriquez at FPA Capital.

The question is how to capture the higher returns of value stocks in a low cost index fund. Unless it is done with an index fund you are faced with the old problem--- higher management expenses and frequent management failures will eliminate your ability to capture the higher return of value stocks. Of the 344 mutual funds in the Morningstar database that invest in large value stocks, for instance, only 127 of them did better than the S&P 500 Index over the last 15 years.

The most promising current research with a value tilt comes from Robert Arnott, editor of the Financial Analysts Journal and principal at Research Affiliates in Pasadena. His "fundamental indexing"--- an index based on dividends, sales, and book value rather than simple market capitalization--- incorporates a value bias. It also eliminates the systematic over-purchasing of popular stocks simply because they are popular. (You can read my column about it on my website, www.scottburns.com.)

Value funds, index or managed, buy stocks with relatively low price/earnings ratios. It isn't necessary to also screen for high dividends because a high dividend yield and a high P/E ratio are mutually exclusive. A growth stock with a P/E of 50, for instance, could yield no more than 2 percent even if it paid out all of its earnings. A value stock with a P/E of 10, on the other hand, could have a yield of 10 percent if it paid out all of its earnings, 5 percent if it paid out half of its earnings.

One reason retired investors should have a particular interest in value investing is that it will increase their dividend income, making it less painful to sit through market declines. Recently, the 30 day SEC yield on the Vanguard Value Index fund was 2.53 percent. The yield on the Vanguard Index 500 fund was 1.64 percent.

For the moment, the best way to pursue value investing in the Couch Potato portfolios is to substitute a fund like Vanguard Value Index for Vanguard Total Market. The substitution, however, is a mixed blessing. When you invest in an index of the value stock components of the Russell 1000, you lose the higher return benefit of small capitalization stocks.

One alternative: Invest in the iShares Russell 3000 Index Exchange Traded Fund (ticker: IWW, more information at www.ishares.com). This index includes the value stocks of both the Russell 1000 index and the Russell 2000 index. Over the last 12 months and 3 years this fund has beaten the S&P 500 index handily but trailed the Russell 1000 value index by a small amount.

On the web:

The Arnott column