One of the most common bits of investment advice is to invest in index funds. But which index funds? Are all the index funds the same? If not, what should you look for in choosing an index fund?
First, we need to understand what an index fund is and what the benefit of investing in them is. An index fund is simply a mutual fund that tracks a given index. The main benefit is that the lack of active management typically makes them much cheaper (in fees, trading costs, and taxes) than actively managed funds and low cost has been shown to be one of the best indicators of superior future performance in mutual funds. That’s because many actively managed funds are so big they essentially own the same stocks as their index so they can be thought of as “closet index funds” with higher fees. Other funds may take big bets to differentiate themselves but any out-performance seems to be mostly a factor of luck since their overall average performance is about the same as the index minus fees and the higher earners actually do worse than average going forward.
One big difference between index funds is the index that the fund uses. Some, like the S&P 500, which consists of 500 of the leading companies in the US, are fairly broad and diversified (although the S&P still leaves out international stocks and small and mid cap domestic stocks. However, there has also been a proliferation of indexes based on very narrow slices of the overall stock market. Many are made up of only a single sector or industry. You’ll need to buy many of these to make sure you’re properly diversified.
As people have been catching on to the downsides of active management, some actively managed funds are also cleverly marketing themselves as index funds by creating their own “indexes” to base their funds on. The problem is that these funds are typically much more expensive than traditional index funds because it costs money to create these indexes and they change their composition more often, causing the funds to incur more trading costs and taxes. To gauge the true cost of a fund, you can look at the expense ratio, which is the fee the fund charges, and the turnover ratio, which is how often the fund trades and can be used to approximate the fund’s trading costs and taxes.
As you can see, not all index funds are the same. But can some indexes actually be better than traditional ones? Next week, we’ll look at equal weight and “fundamental” index funds that are designed to outperform traditional index funds.