All index funds are created equal. That’s what many fund families want you to believe. But it can’t be further from the truth. The difference is big enough, it could force some passive investors to actually do some work.
Unfortunately we might want to put some time into researching index funds before investing in them. It seems that not all index funds are created equal.
Specifically, similar index funds are not equal when it comes to performance. Which really doesn’t make sense. Aren’t they supposed to track the same index? Invest in the same stocks and/or bonds? Have the same annual performance results?
I could easily turn this into an index investing versus stockpicking argument but I won’t. Both sides make their point even though I tend to lean more toward one than the other. I’ll keep it safe and say that the better of the two depends on how much time you’re willing to put into research. So there must be a place for index funds otherwise we’d all be researching stocks. So, let’s focus on the index investing side for a moment.
The most common index fund available is built to track the S&P 500. You’d think that all those funds would perform equally. But they don’t. Not after you factor in expense ratios, tracking errors, fund structure, portfolio turnover, and transaction costs. It seems some fund families do a better job at this than others.
When we consider that most people consistently add to their nest egg on a monthly basis, this is even more important. It’s easy to think that every index fund is the same. But they are not and the difference, as shown below, could be costing you money.
Quick S&P 500 Index Fund Comparison
A fund screen for S&P 500 Index funds found 144 funds that are built around the goal of tracking the S&P 500.
| Best And Worst Returns Of S&P 500 Index Funds Over Multiple Timelines | |||||
| Performance | 1 Month | YTD | 3-Year | 5-Year | 10-Year |
| Best Return | 4.24% | 11.14% | 14.18% | 1.21% | 6.37% |
| Worst Return | 3.92% | 9.61% | 11.44% | -0.80% | 4.82% |
| S&P 500 | n/a | 10.69% | 14.13% | 1.13% | n/a |
| Based on stats taken from the Rueters fund screener 8/1/12. | |||||
Some index funds lived up to their name. The bad news is many of those funds fell short of that goal.
It’s Only 2%
The difference between the best and worst averages about 2%. Which isn’t much or is it? That 2% difference will add up. You can only image what that 2% difference could mean for a retirement account over several decades.
| Growth of $100,000 Over Multiple Timelines | |||||
| Annual Return | 3-Year | 5-Year | 10-Year | 20-Year | 30-Year |
| 1% | $103,044 | $105,125 | $110,512 | $123,130 | $134,969 |
| 2% | $106,178 | $110,508 | $122,120 | $149,133 | $182,121 |
Look at it this way, you’re losing money by not being diligent with your index fund choices. Here’s a few things to watch out for are:
- Costs – I’ve said it before, but costs kill returns. The lower the expense ratio the better.
- Portfolio Turnover – This goes back to costs. Sometimes it can be avoided, but not when Standard and Poor’s makes a change in their index. When a new stock is added to an index, an old one is dropped. Index funds have to follow suit, adding to the transaction costs. Of course, newly added stocks outperform leading up to any official changes and dropped stocks underperform. Meaning index funds are buying high and selling low with each change. Which negatively affects performance.
- Investment Strategy – take the time to read the prospectus. What exactly is the strategy. What percent will be invested in the same assets of the index. One of the worst performing S&P 500 funds had a strategy of investing 80% of its assets in the underlying index. So 20% of the fund can be invested elsewhere or sitting in cash. That’s a lot of wiggle room for an index fund and a big reason it fell short.
All of these affect performance. Over the long-term, the funds that manage these areas better, tend to perform more closely to the index tracked. If you lean toward the passive investing mantra, at least find an index fund that does what it says it will do. Not one that falls short every year thanks to the issues laid out early.
