The benefits of low-cost index mutual funds and ETFs are all over the news. They were front and center in the recent PBS Frontline Special The Retirement Gamble. Index funds are a great tool for investors of all ages; in many cases these passively managed funds beat the majority of their actively managed peers within the same investment style. However, investing in index funds takes work, especially with the proliferation of new index products that continue to hit the marketplace.
Costs matter when investing. One of the biggest lures of index fund investing is that many of these products provide a low cost way to investment in a given segment of the market. If you are looking for an index fund that mimics the S&P 500 there are many great low cost alternatives such as the Vanguard 500 Index Fund (Ticker VFINX) with an expense ratio of 0.17% or the SPDR S&P 500 Index ETF (Ticker SPY) with an expense ratio of 0.09%. On the other hand, there is also the Rydex S&P 500 A (Ticker RYSOX) with its expense ratio of 1.51%. How big of a deal is this difference?
A $10,000 investment in the Vanguard 500 fund made on May 31, 2006 and held until May 15, 2013 would now be worth $15,064. That same investment in the Rydex S&P 500 fund would be worth $13,798 or 9.2% less for an investment in a mutual fund tracking the same index as the Vanguard fund.
Understand the underlying index
In the wake of the 2008-2009 market downturn new index products, especially in the ETF space, have proliferated. ETF providers are falling all over themselves to bring new index products to the market hoping to attract assets. Like any investment, investing in an index fund or ETF requires that you understand what it is that you are buying.
When I think of indexing I think of the traditional, basic index products that track benchmarks such as the S&P 500, the total U.S. stock market, the total non-U.S. market, the domestic bond market, etc. Additionally I typically use index funds to benchmark the U.S. small and mid cap equity spaces, real estate, and emerging markets equity among others.
Several months ago Market Watch’s Chuck Jaffe cited a Vanguard report that found “1,400 U.S. listed ETFs track more than 1,000 different indexes. But more than half of these benchmarks had existed for less than six months before an ETF came along to track it.”
As an investor this should be a huge red flag. What this study says is that many of these new index products were developed much like the monster in the Mel Brook’s classic Young Frankenstein. Look back-testing is not inherently bad and many of these new index products are appropriate for professional traders. However if you are looking to index in the fashion that Vanguard founder John Bogle and others espouse then you should consider sticking with index products that track known, battle-tested market benchmarks.
Asset allocation is still vital
Whether you use index products as a portion of your overall portfolio in conjunction with other investment vehicles such as actively managed mutual funds or individual stocks, or if you invest in index funds exclusively you still need to develop and asset allocation for your portfolio. As I say frequently on this blog, this should be done as an outgrowth of your financial plan.
Even a seemingly simple strategy of investing in a total U.S. stock market fund, a total international stock market fund, and a total bond market fund still requires that you determine how much to invest in each fund, that you monitor your allocation and rebalance when needed, and that you review and adjust your target allocation as you age or if your situation changes.
Index funds and ETFs are a great investment tool. Like any tool it is important that you select the right index product and that you manage your portfolio properly.
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