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Index Funds: Know What You Are Buying

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The financial press and many financial advisors advocate the use of index mutual funds and ETFs in your portfolio.  I concur.  Index funds offer many advantages:

  • Low costs
  • Style purity
  • In many cases, better performance than a majority of actively managed funds within the same investment style.

In a recent study, Morningstar indicated that one of the key predictors of a fund’s success is low expenses.  I use index mutual funds and ETFs extensively across my practice for the reasons listed above.

That said, like anything else in the investing realm, picking the right index fund takes some work.   Here are a few thoughts to consider as you go forward.

Low expenses are critical.  Let’s take a look at two funds tracking the popular S&P 500 index.

Fund Ticker Cumulative Return Annualized Returns Growth of $10,000
Vanguard 500 Index Inv VFINX 28.84% 2.21% $12,885.29
Principal Large Cap S&P 500 Index A PLSAY 19.01% 1.51% $11,903.55

The above chart, taken from information from Morningstar assumes the investment of $10,000 in each on 12/31/2000 and that the funds were held with all distributions reinvested through 7/31/2012.

While the returns on both funds are anemic, the difference between these two funds which track the same index and should have virtually identical portfolios is their expense ratios.  The Vanguard fund sports an expense ratio of 0.17% while the Principal funds expense ratio is 0.62%.  The difference in dollars accumulated is about 8.3% between the two funds.

What index does the fund track?  

Let’s look at some popular ETFs in the Mid Cap Blend style:

Name Ticker Avg. Market Cap $ millions Index Tracked
ishares Russell Mid Cap Index IWR 6,906 Russell Mid Cap
SPDR S&P 400 Mid Cap MDY 3,354 S&P 400
Vanguard Mid Cap Index VO 6,138 MSCI Mid Cap 450

All three of these ETFs are solid choices but they follow different indexes with somewhat different characteristics.   For example the smaller average market capitalization of the SPDR product means that it will outperform the other two ETFs during periods where smaller stocks lead the market, as happened over the five year period ending July 31.  By contrast during the three year period ending July 31, larger stocks outperformed, and as such the SPDR product trailed the other two ETFs.

Does the index make sense?  Recently Chuck Jaffe wrote an excellent piece on Marketwatch.com entitled “These ETFs get an “F” for fiction” in which he was critical of the proliferation of new index ETFs based on questionable underlying indexes.  Jaffe cites a recent study by Vanguard indicating that there were 1,400 U.S. listed ETFs that tracked about 1,000 different indexes.  The report further concluded that over half of these indexes existed for six months or less prior to the inception of an ETF designed to track it.

What does this mean for you as an investor?  It means that you may be buying into an index product that has only been tested “in the lab” so to speak.  This reminds me of the mid to late 90s when I made a career switch into the financial advisory world.  At that point in time mutual funds were proliferating at the same rate as the Duggar family (of TLC fame).  Many of the new funds made little sense from an investment standpoint and were brought to market to capitalize on the Bull Market of that time period.  Fast forward to today and we are seeing much the same thing with ETFs, the popular investment structure of this day.  Fund companies want to ride the wave here and can’t seem to get new ETFs to market fast enough.

Tom Lydon, editor of ETF Trends is quoted in Jaffe’s article:

“You’ve got about 1,400 ETFs today, and about 95% of the money invested is in the largest 10% of those funds,” Lydon said. “You have plenty of choice, and you’re not really missing out on anything if you don’t buy the newest ETF out there. … If you see some creative new index with an ETF, watch it for awhile. Maybe it turns out to be something you want to own, but you don’t need to take the risk and jump in right away, when they’re saying the strategy is proven but you know it’s really not.”  

Here are a few tips when considering an index mutual fund or ETF:

  • Rule number one, low cost is good.  This is also rule numbers 2-10.  Paying up for an index fund, in my opinion, makes no sense whatsoever.
  • I tend to stick with more mainstream indexes for my clients.  I am an asset allocator and I want to have an understanding of the type of performance that I can expect over various market conditions.  We may not like that results (as in 2008) but they were not unexpected based on market conditions.  With some of these new, back tested only, index products it is hard to tell how they will react under real market conditions.
    • In short, understand the underlying index of the fund and how it fits with your other holdings.
  • Buy right.  By this I mean look at how you will be investing.  Will you make larger lump-sum purchases?  If so paying a transaction fee for an ETF or for a Vanguard fund if investing someplace other than Vanguard (Schwab for example) really won’t make much of an impact.  However, if you will be making smaller purchases, say via dollar cost averaging, it pays to look around.
    • At Vanguard, once you meet their minimums, additional investment amounts are fairly low for their mutual funds.  Additionally you can buy their ETFs with no transaction costs.
    • Fidelity offers a number of ETFs without a transaction fee.
    • Schwab has developed their own series of index ETFs for which there are not transaction fees for Schwab account holders.  I use some of these ETFs for smaller purchases for some clients.
    • As with anything, please check on any restrictions at these or other firms offering similar deals.
  • Many 401(k) plans offer index funds as a choice.  In some larger plans participants may be able to reap the plan’s buying power and have the opportunity to buy ultra low cost institutional index funds.
  • Vanguard is a prime example here, always make sure you are in the lowest cost share class that you are eligible for.

Index funds can be a great choice for your portfolio.  Always fully understand what you are buying and why you are buying it.

Please feel free to contact me with your investment and financial planning questions.

 

Photo credit: nikikl

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Comments

  1. I’m a huge proponent of index fund (and etf) investing. Although, I avoid the more esoteric varieties.

    • Roger Wohlner says:

      Thanks for the comment Barb. These esoteric indexes are often based on dubious indexes that may or may not pan out under real market conditions.

      • Jeremy says:

        Yes, my favorite esoteric “ETF” de jour was the Claymore Stealth Fund (now Guggenheim) with bottom up stock picking designed to sift through equities that “flew below the radar” of the analysts screens. Yikes. The Claymore name just made me think about mines and explosives; This one was bound to blow up. This ETF now aspires to pick a subset of the Wilshire Micro-Cap Index. Too bad there aren’t ETFs based on Fama French or even CRSP indices.

        • Roger Wohlner says:

          Jeremy thanks for your comment. I agree re the Claymore name. ETFs are a great tool for investors, sadly their popularity has spawned so many new entrants that in my opinion just don’t measure up to the basic straightforward index products.

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