Index funds have not only made investing low-cost, but they’ve also made it incredibly simple. You don’t have to select individual stocks or do any kind of research on companies. And you can be guaranteed that your investment at least won’t underperform the market (though it won’t outperform it either!).
And since you’re investing in entire markets, it makes asset allocation easier than ever before. All you need to do is decide what percentage of your portfolio you want in a particular asset class, and you can cover it with a single index fund.
But the simplicity factor can also get in the way of choosing the right index fund. For example, if we assume all index funds are basically the same, then the only distinguishing factor is the fees within the fund.
Fees should never be ignored, but when it comes index funds, there are a whole lot of other considerations before making your choice.
Fees–Where Most Investors Look First
The typical expense ratio is about 0.20% for index funds. This is just an average, so you can generally assume any fund with a lower fee will be a preferred choice.
For example, the Vanguard 500 Index Fund Investor Shares (VFINX) has an expense ratio of just 0.14%.
How much difference would that make over the long-term?
- A $10,000 investment in an index fund returning 10% with a 0.14% expense ratio would grow to $167,953 over 30 years.
- A $10,000 investment in an index fund returning 10% with a 0.20% expense ratio would grow to $165,224 over 30 years.
The difference is $2,729 over 30 years or about $91 per year.
Certainly, you’ll want to get the highest return you possibly can on your investment. But there may be other factors that can easily offset a difference of only $91 per year.
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How Closely Does the Fund Match the Index?
In theory, at least, an index fund should match the performance of the underlying index exactly. In the real world, however, that doesn’t usually happen.
In index fund is designed to replicate a particular index. But there are factors that can cause it to vary slightly from the index.
Those factors include:
- The fund’s expense ratio
- Rebalancing expenses
- Cash drag (for management purposes, the fund will hold a very small sliver of cash that can reduce performance in a rising market, or improve it in a falling market)
- Tax on dividends
The index fund is subject to each of these variables, while the index is not. With nearly every index fund, the fund itself will at least slightly underperformed the index. It’s just a matter of to what degree it will.
You can determine what this variance is by looking at the performance chart provided with each index fund. For example, the performance data for the iShares Core S&P 500 ETF shows that the fund itself has underperformed the index for each of the five time periods indicated (compare the Benchmark to Total Return.) The difference is only slight, but it’s consistent across the board. This is typical of index funds.
This variance in performance against the index must be factored into a decision to go with one fund versus another. This is especially important because the variance reflects the effect of the fund’s expense ratio.
It may be possible for one index fund to have a lower performance variance against the index than another fund, despite having a higher expense ratio. This could be an indication the fund has a lower cash allocation or rebalancing fees. Whatever the reason, it will be the better choice over the fund with the lower expense ratio.
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The Underlying Index
Though the S&P 500 index has become the most common stock index used by investors, it’s actually one of several. It represents (roughly) the stocks of the 500 companies in the US with the largest market capitalization.
While the S&P 500 index has performed extraordinarily well over the past decade, there have been other time frames where different indexes have performed better.
Common stock indexes also include:
- The Dow Jones 30 Industrials, representing the very largest companies.
- The Russell 2000, representing an even broader range of stocks than the S&P 500.
- Wilshire 5000, which is the broadest index, taking in virtually the entire spectrum of publicly traded companies in the US.
If the direction of the stock market were to shift, say favoring stocks in smaller companies, the Russell 2000 and Wilshire 5000 would likely outperform the S&P 500.
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While investment in an index fund based on either the Russell 2000 or the Wilshire 5000 would give you exposure to both mid-cap and small-cap companies, there are index funds based on both categories. Should either mid-caps or small caps begin outperforming large-cap stocks, you might want to consider investing in an index that will represent a pure play in these market segments.
For example, the Schwab U.S. Mid-Cap ETF (SCHM) is tied to the Dow Jones U.S. Mid-Cap Total Stock Market Index. That is, the fund is invested entirely in mid-cap stocks.
On the small-cap side, the iShares Russell 2000 ETF (IWM) is tied to an index composed of small-capitalization U.S. equities (the Russell 2000 index).
In a market that favors either mid-cap or small-cap stocks, either can be a better choice than investing in a fund tied to the S&P 500. This may be the case coming out of a recession or off the bottom of a significant bear market, where new market leadership takes hold, often led by smaller companies.
At any given point in time, certain market sectors may be outperforming the general market. This can be the case with specific industries, such as high tech, energy, healthcare, or precious metals. Any of these industries may even be significantly outperforming the overall market during market downturns.
For example, the Invesco S&P 500 Equal Weight Tech ETF invests entirely in high tech stocks, based on the S&P 500 Equal Weight Information Technology Index. The fund is currently invested in 68 large and mid-cap stocks of companies within the S&P 500.
If you believe technology stocks, or any other sector, is likely to outperform the general stock market, you may favor investing in an index fund based on that sector. Fees will still be a factor when compared to other funds in the sector. But you also have to look closely at the variance between the fund and its underlying index as a more specific indicator of long-term performance.
ETFs vs. Index Mutual Funds
It’s important to understand that “index funds” is a general term. It can apply to both exchange-traded funds and mutual funds.
Generally speaking, ETFs tend to be index funds. That makes them passive investments since they’re tied to the underlying index. The fund will have very little turnover in its composition, which will result in very low expense ratios and little in the way of tax generating capital gains sales.
Mutual funds are primarily actively managed funds. That means they trade stocks within the fund in an attempt to outperform the general market. Because of this higher level of both management and trading, they have higher expense ratios and are likely to generate a larger number of taxable capital gains.
But just as is the case with ETFs, mutual funds can also be index funds. What’s the difference between the two?
Mutual funds usually have a minimum initial investment. This can be $3,000 or more. ETFs can be purchased in much smaller denominations, and are better suited to dollar cost averaging. ETFs also generally have lower expense ratios than mutual funds.
However, ETFs usually require you to pay a commission when buying them. If you are acquiring an index mutual fund through a fund family, there may be no fee required to make the investment. In addition, index mutual funds typically allow you to automatically reinvest dividends into the fund. ETFs will pay dividends out in cash, generating a potential tax liability.
You’ll have to decide which of the two will work better for your situation, which may outweigh small differences in fees between the two.
Different Indexes for Different Market Types
So far we’ve been discussing US-based index funds because they’ve largely outperformed international markets over the past decade. That leadership hasn’t always been true. In different times, US stocks have lagged behind international markets. And some country-specific markets have easily outperformed the US.
There are at least three ways to play this shift once it occurs, and it certainly will at some point:
- International developed market funds, such as the iShares MSCI EAFE ETF (EFA), which matches an index that invests in developed countries in Europe and Asia, but not the US and Canada. This will be a choice if international developed markets begin outperforming the US.
- International emerging market funds, such as the Vanguard FTSE Emerging Markets ETF (VWO). It invests in an index of companies in emerging market countries, that may outperform US markets in certain economic conditions.
- Specific country funds. For example, if you believe the stock market in Japan will outperform the US, you can invest in an index ETF, such as the iShares MSCI Japan ETF (EWJ). You can do this with any country you believe holds promise to outperform the US market.
Even if the fees on one of these international funds are higher than a given US index fund, you may still choose that fund as a way to take advantage of larger expected gains.
Final Thoughts on Not All Index Funds are Created Equal
For the past several years investors have been running with a relatively small number of index funds, with fees being a major consideration. Yes, fees are important, but the performance variance of the fund compared to the underlying index may be even more important, since expense ratios are part of that calculation.
But there may be other instances where you may want to move into radically different investment sectors, that may involve higher fees. In that case, the potential for the higher performance of that specific market may more than outweigh a lower fee in a more conventional index fund.
With the recent volatility in the stock market, investors may be forced to look beyond the funds that have proven to be so reliable in the recent past. Be prepared to look beyond fees as the primary criteria.
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