Alert: Index Funds Aren't Created Equal

One of the age-old arguments infavor of physicians investing inindex mutual funds is the lowcostfactor. Operating expenses and portfoliotransaction costs are minimal andthere are no advisory fees. If you're comfortablewith long-term returns that mirrorthe S&P 500, index funds should be apart of your plan. And, because all S&P500 index funds are composed of thesame stocks, it doesn't matter which indexfund you own, right? Well, not exactly.

BusinessWeek

According to a report,not all index funds are equal. While somecome very close to matching the index'sreturn, others miss by wide margins. Thereasons for this include high expenseratios and managers who sit on cash andpay inflated trading commissions.

Strive for the Norm

The article explains that deviationfrom the S&P 500, whether higher orlower, is called tracking error. In 2003, forexample, the deviation was considerablylower since more than 80% of the S&P500 index funds tracked by Morningstarfell short of their performance ideal.Even more startling, according toMorningstar, is that in 2003, the averageS&P 500 fund deviation was equal to thefund's expense ratio plus an additional0.38%, or 38 basis points.

According to Gus Sauter, Vanguard'schief investment officer, index fundsshould be within 5 basis points—10 atthe maximum. Consider that shortfall of38 basis points compounded over time.The article notes that someone whoinvested $10,000 in the S&P 500 in 1995would have had $28,179 at the end of2003, or $865 more than an identicallypriced investment that returned 0.38%less each year.

Pinpoint Culprits

BusinessWeek

One of the biggest factors contributingto tracking error is a fund's expense ratio.The costs are deducted from a fund's earnings,so the lower the expense ratio, thesmaller the tracking error. According tothe article, the average S&P500 fund charges approximately 0.48%, or48 basis points, of assets. However, expensesrange from 0.15% (State Street GlobalAdvisors' S&P 500) to as high as 1.5%.

Commissions also contribute to trackingerror. The article explains, "These feesaren't factored into a fund's expense ratio,but are deducted when stocks are boughtand sold." As a result, if a fund manager ispaying high commissions as a way to generatesoft dollars (ie, credits that can beused to pay for investment research), thefund's tracking error can grow quite large.

Note:

But don't simply consider total commissionspaid. The article points out that theMorgan Stanley S&P 500 Index fund paid$271,513 in commissions in fiscal year2002, while the Vanguard 500 Index fundpaid $4.386 million. When compared as apercentage of assets, the Morgan Stanleyfund rate was 0.0169% compared withVanguard's 0.0057%. Check theStatement of Additional Information in afund's prospectus to find out how much isbeing paid in commissions.

BusinessWeek

According to the article,some of the funds that finished 2003closest to the S&P 500 were the FidelitySpartan 500 Index (deviation of 0.01),Vanguard 500 Index (0.01), EvergreenMarket Index (–0.01), and T. Rowe PriceEquity Index 500 (–0.01). The article addsthat high index fund expense ratios arelikely to decline due to increased scrutinyby the SEC. However, that doesn'tmean tracking error is going to goaway.