4 Traits Of A Great Index Fund

By Tim Parker | March 28, 2012 AAA

The average consumer has likely never heard the name, John Bogle. Bogle, founder of the Vanguard Group and creator of the first index fund, doesn't get as much love as he deserves from the investing world. The company he founded now has $1.7 trillion under management, but he was forced to retire at the mandatory age of 70 and for many industry professionals, the hope was that his retirement would silence a man who was fiercely critical of the world of mutual funds. That didn't happen.

Bogle has long said that the mutual fund world suffers from high fees and lack of accountability to shareholders, as well as too much turnover within the fund, producing extra taxes and commissions.

However, Bogle isn't just hard on the professionals. He and many others believe that trying to be a better stock picker by selecting individual stocks and trying to buy them at just the right time, is a mathematical impossibility. If everybody is trying to beat the market but everybody is the market, they're almost trying to outsmart themselves.

SEE: Stop Paying High Mutual Fund Fees

Bogle created the index fund as a means of removing the many variables that are nearly impossible to overcome. He said of the index fund, "index funds eliminate the risks of individual stocks, market sectors and manager selection. Only stock market risk remains."

However, even index funds have variables and picking the wrong funds can have the same negative effect on your portfolio as other funds. If you're planning to fill your portfolio with index funds, here's what you should look for in a high-quality fund.

1. Low Expenses
Index funds, by their nature, are low-fee instruments, but even Vanguard has funds like the 500 Index Admiral Shares, with an expense ratio of .05%, and the Global ex-U.S. Real Estate Index, which has a 0.50% ratio. Other companies have funds that are even higher.

Picking funds solely based on fees isn't an advisable strategy, but minimizing expenses as much as possible always translates to a higher portfolio balance.

2. Correlation to the Underlying Index
What good is an index fund if it isn't correlated to the market? If the S&P 500 is up 1% during the past six months but your S&P 500 index fund is only up 0.7%, there's a correlation problem likely resulting from high fees eroding the performance. There will not be 100% correlation but it should not be far off. Make sure to check the correlation over longer periods of time, as well.

SEE: The Importance Of Correlation

3. No Narrow Funds
The reason there are so many index funds available is because there are a lot of indexes and most aren't worth your time. Although it might make you sound sophisticated to say you own the iShares MSCI Israel Capped Investable Market Index Fund, investing in a fund that is confined to Israeli holdings is a lot like stock-picking, except that you're attempting to time the performance of a single country, and you're paying 0.59% in expenses to do it.

4. The Index Is Easy to Understand
Most investors who have the knowledge and experience to pick their own funds, know and understand the S&P 500. It's an index based on 500 stocks representing a cross section of the economy. You could invest in the ADCARAB index fund (even this ticker looks intimidating) but before you do that, you'll need to know a lot about the S&P Pan Arab Composite Large/Midcap Index. If you don't, you might want to stick to funds that track indexes, like the Russell 2000 and the Nasdaq.

SEE: Index Investing Tutorial

The Bottom Line
Bogle believed in keeping investing as simple as possible by removing variables that were largely out of the control of most investors. The index fund does that by removing stock picking, money managers, large amounts of turnover and other expenses that come with actively managed funds. He believes, and other research agrees, that trying to beat the market will not result in large-scale gains over time.

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