What to look for in an index fund

Morningstar, Inc.


Are index mutual funds boring? Nearly always, and when they aren't, there's often something wrong. But boring investing isn't necessarily bad investing. In fact, index funds have given actively managed funds a run for their money over the long haul. Moreover, index funds are often appealingly simple. Unlike actively managed funds, investors don't need to worry too much about their manager departing or their strategy veering off course.

Given their simplicity, sorting through index funds to find the best of breed doesn't require as much legwork as a search through actively managed funds would. Still, with the proliferation of exchange-traded funds and new indexing methodologies, there are more choices than ever before, and not all of them are worthwhile. Below, we touch on the basics that investors should consider before investing in an index fund, including low fees, hidden costs, and reasonable construction.

A penny saved is one more penny invested

We often say, "All else equal, go with the cheaper fund." That makes intuitive sense. If two funds practice the same strategy in the same category and have equally skilled managers, the lower-priced one will likely edge past its competitor over the long haul.

In the indexing world, "All Else Equal" is often the status quo. Think about it. Regardless of their assigned category, index funds should all have the same purpose: Closely mimic an index that captures the characteristics of the market segment that the index fund wishes to track. Thus, index funds covering the same area should provide the same exposure to the same market forces. In the end, expenses should determine which of these commoditylike investments earn the highest returns. And while a fee difference can seem small, it can make a big difference over the long haul. For example, a $10,000 investment in a fund that charges 0.81% for exposure to the broad-based S&P 500 would have grown to $10,906 over the next nine years. The same amount invested in a comparable fund that charges 0.15%, would have grown to $11,579 over the same period.

No-see-'em fees

Fees aren't always captured in the expense ratio, unfortunately. Transaction costs, which reduce the return from a trade, come in the form of brokerage commissions and market impact costs, meaning the extent to which a stock's price moves as a fund is buying or selling shares. The more trading, the more the transaction costs can grow. Thus, it often makes sense to shy away from an index fund that trades frequently.

Transaction costs can add up for other reasons besides turnover. Some indexes, such as the S&P lineup, are under the direction of a committee that uses a mix of qualitative and quantitative factors to decide when to include a new stock in the index and when a current constituent should be kicked out. Thus, it can be hard to determine which stocks will be added and which will be dropped. At other indexes, however, the construction is much more quantitative and transparent. At the Russell indexes, for example, once a year, at the start of the summer, the indexes change up their holdings to include the stocks that have grown into the appropriate style and market-cap range and kick out the ones that no longer fit. Traders who know the index parameters and follow the stock market will have a good idea of what changes the indexes will make. In order to profit from the upcoming adjustments, they can buy a stock that's likely a new index member ahead of time, thereby pushing the stock price higher and making the change more expensive for the index and the index funds that track it. One study has estimated that this process, called front-running, has cost Russell 2000 Index trackers 1.3% each year. The Russell indexes now incorporate buffer zones, which will muddy the waters a bit by slowing the index additions and deletions, but, given that the methodology is still transparent, it's likely that persistent traders will still be able to profit at index-fund investors' expense.

Got your own quick trigger finger?

Fees for buying and selling aren't limited to indexes and fund managers. When investors buy and sell mutual funds or ETFs, they may also rack up expenses. This can be particularly costly in the ETF realm, because investors pay brokerage commissions to buy and sell. Typically, when in pursuit of hot returns, investors don't look back to gauge how much they lost to commissions and other transaction costs when they jumped out of one ETF and into another, but the fees can add up. That's true even for a long-term ETF investor because just adding more to one's holdings in an ETF generates a commission.

Beware the gimmicks

Outside of costs, it pays to investigate the underlying index methodology before investing. Leveraged funds, for example, sound enticing but come with hefty expense ratios. Inverse funds (funds designed to move in the opposite direction of the index) are particularly hard to use, given that markets trend up over time and timing the drops is tough to do.

We're skeptical of quirky sector funds and ETFs for much the same reason. The theory is that investors expecting certain industries to boom and bust will be able to use these slivers effectively, but, like many theories, that one doesn't often work too well in reality. Not only is it tough to time correctly, but anyone who has held one of these quirky sector funds for the long haul has earned market-lagging returns.

Of course, innovation can sometimes lead to index funds offering all the traditional indexing advantages with a few of their own as well. Still, it seems for every good indexing idea, there are four more questionable ones, so take a close look at the underlying index construction. For most investors, it often makes sense to opt for a broad-based index fund whose success isn't dependent on the accuracy of your market-timing.

The final word

To make money in index funds, keep it simple. Remember to keep expense ratios down, and don't overlook the hidden costs. Also, don't compromise a traditional indexing benefit, such as broad diversification or low fees, for an interesting idea. You could very well end up on the losing end of that proposition if you do.


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