Index funds, which track an underlying market index have grown in popularity with investors over the years. A fund might track the S&P 500 or Dow Jones Industrial Average, allowing investors to own each of the holdings within those indices.

Although index funds should replicate their respective indices, no fund's performance is guaranteed to be the same as similar funds; nor will a fund necessarily replicate the index it tracks. Although the differences between index funds can be subtle, they can have a major impact on an investor's return over the long term.

Key Takeaways

  • Index funds, which track an underlying market index have grown in popularity with investors over the years.
  • Fees and expenses ratios or operating expenses can vary between index funds and erode an investor's return.
  • An index fund might not track the underlying index or sector exactly causing tracking errors or variances between the fund and the index.
  • Some index funds might only hold a few components, and the lack of diversification can expose investors to risk of losses.

Understanding the Hidden Differences Between Index Funds

An index fund is a type of exchange-traded fund (ETF) that contains a basket of stocks or securities that track the components of an existing financial market index. For example, there are index funds that track the Standard & Poor's 500 Index. Although investors can't buy an index per se, they can invest in index funds that are designed to mirror the index. In other words, an index fund tracking the S&P would have all 500 stocks from the S&P 500 in the fund. Index funds tend to provide investors with broad market exposure or exposure to an overall sector.

As a result, index funds are passive investments, meaning that a portfolio manager is not actively stock picking by buying and selling securities for the fund. Instead, a fund manager selects a combination of assets for a portfolio intended to mimic an index. Because the fund's underlying assets are held and not actively traded, operating expenses are usually lower than actively-managed funds.

At the onset, it might be reasonable that the index fund should track the index with little difference and other funds tracking the same index should all have the same performance. However, a deeper look uncovers numerous disparities across fund types.

Expense Ratios

Perhaps the most distinctive hidden difference between index funds is a fund's operating expenses. These are expressed as a ratio, which represents the percentage of expenses compared to the amount of annual average assets under management.

Investors who invest in index funds should, theoretically, expect lower operating expenses since the fund manager doesn't have to select or manage any securities. However, operating expenses can vary between funds. Expenses are very important to consider when investing since expenses can erode an investor's return.

Consider the following comparison of 10 S&P 500 funds and their expense ratios as of April 2003:

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Image by Sabrina Jiang © Investopedia 2020

The different bars in this chart represent different funds. Bear in mind that the yearly return of the S&P 500 as of the end of April 2003 was approximately 5%, taking into specific account that expense ratios range from 0.15% to almost 1.60%. If we assume that the fund tracks the index closely, a 1.60% expense ratio will reduce an investor's return by about 30%.

Fees

Index funds with nearly identical portfolio mixes and investing strategies can have different fee structures. Some index funds charge front-end loads, which are commissions or sales charges applied upfront when the initial purchase of an investment occurs. Other funds charge back-end loads, which are charges and commissions that occur when the investment is sold. Other fees include 12b-1 fees, which are annual distribution or marketing fees for the fund. However, the 12b-1 fee can be charged separately or be embedded within the fund's expense ratio.

The fees, along with the expense ratio, should be considered before buying an index fund. Some funds may appear to be a better buy since they might charge a low expense ratio, but they might charge a back-end load or a 12b-1 fee separately. The fees and expense ratio, when taken cumulatively, can dramatically impact an investor's return over time.

Typically, larger, more established funds, such as the Vanguard 500 Index fund (VFINX) tend to charge lower fees. The lower fees could be the result of management experience in tracking indexes, a larger asset base, which could enhance the ability to use economies of scale in purchasing the securities. Economies of scale are cost savings and advantages reaped by large companies when they can buy in bulk, thus lowering the per-unit cost.

Tracking Errors

Another method for effectively assessing index funds involves comparing their tracking errors and quantifying each fund's deviation from the index it mimics.

Tracking error measures how much divergence occurs between the fund's value and that of the index the fund it's tracking. The tracking error is usually expressed as a standard deviation, which shows how much variance or dispersion exists between the fund's price and the average or mean price for the underlying index. Sizable deviations indicate large inconsistencies between the return of an index fund and the benchmark

This large divergence could be an indication of poor fund construction, high fees or operating expenses. High costs can cause the return on an index fund to be significantly lower than the index's return, resulting in a large tracking error. As a result, any deviation can create smaller gains and larger losses for the fund.

The figure below compares the S&P 500's return (red), the Vanguard 500 (green), the Dreyfus S&P 500 (blue) and the Advantus Index 500 B (purple). Notice the index fund's divergence from the benchmark increase as expenses increase.

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Image by Sabrina Jiang © Investopedia 2020 

A Fund's Holdings

Just because a fund says index fund in its name, doesn't necessarily mean it tracks the underlying index or sector exactly. When screening for an index fund, it's important to remember that not all index funds labeled "S&P 500" or "Wilshire 5000" only follow those indexes. Some funds can have divergent management behavior. In other words, a portfolio manager may add stocks to the fund that are similar to what's in the index.

Take for example the Devcap Shared Return fund, which is a socially responsible S&P 500 index fund. As of Jun. 4, 2003, it had an expense ratio of 1.75% and charged a 12b-1 fee of 0.25%. Another fund, the ASAF Bernstein Managed Index 500 B, was categorized as an S&P 500 index fund, but it actually sought to outperform the S&P 500.

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Image by Sabrina Jiang © Investopedia 2020

Sector index funds that track a sector in the economy are often open to subjectivity by the investment manager as to what's included in the fund. For example, the SPDR S&P Homebuilders exchange-traded fund (XHB) is known for tracking stocks in the homebuilding industry. An investor buying the fund might assume it contains only homebuilders. However, some holdings are stocks of companies related to the industry. For example, Whirlpool Corporation (WHR), the appliance manufacturer, the home supply store, Home Depot (HD), as well as Aaron's Inc., which is a rent to own furniture retailer, are all included.

Also, if a portfolio manager for an index fund performs additional management services, the fund is no longer passive. In other words, a fund might have the goal to outperform the index, such as the S&P 500, leading to holdings that include companies and securities outside the index being tracked. As a result, funds with these added selling features typically have fees well above average.

It's important for investors to analyze the holdings of an index fund before investing to determine whether it's a true index fund or a fund that has an index-like name.

Lack of Diversification

Within the index fund category, not all funds listed are as diversified as those tracking an index such as the S&P 500. Many index funds have the same properties as focused, value, or sector funds. However, please remember that focused funds tend to hold fewer than 30 stocks or assets within the same sector. The lack of diversification in sector funds can expose investors to higher risk than a fund tracking the S&P 500, which is comprised of 500 companies within various sectors of the economy.

Special Considerations

Careful investigation of index funds before buying includes making sure that are little-to-no tracking errors and that fees and expenses ratios are low. Also, it's important to understand the investment manager's goal for the index fund and what holdings or investments are included in order to reach that goal. If the goal is considered aggressive, the fund's investments might deviate from the underlying index.

The need to consider fees becomes even more important relative to increased risk factors—fees reduce the amount of return received for the risks taken. Consider the following comparison of Dow 30 index funds:

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Image by Sabrina Jiang © Investopedia 2020 

An investor's risk tolerance and time horizon can impact the choice of investments. A retiree would likely seek index funds that are conservative or low risk since the goal might be to maintain the portfolio and provide income. A millennial, on the other hand, might choose a fund that has a more aggressive investment strategy designed to offer growth since the millennial has more time to make up for any market downturns. Risk tolerance and time horizon are both important considerations when it comes to choosing an index fund.