Think of your trips to the candy store as a child. You'd pick out your favorite candy...let's say it was jelly beans. When you were a kid, orange tasted like oranges and yellow tasted like lemons; but sometime later, Jelly Belly jelly beans came along, and all of a sudden, the yellow jelly beans you purchased might taste like pineapples or bananas ...or even popcorn! 

The lesson here -- that appearances can't necessarily be trusted -- can be applied to index funds as well. Although S&P 500 or Dow Jones Industrial Average index funds should replicate their respective indices, no fund's performance is guaranteed to be the same as others like it; nor will a fund necessarily replicate the index it mimics. The differences between index funds can be subtle, but for the major impact they may have on your long-term financial outlook, they're well worth examining as a part of honing your investment strategy. 

The Moonshot: Index Funds
An index fund is a passive investment. As such, a fund manager selects a combination of assets for a portfolio intended to mimic an index, such as the S&P 500. Because the fund's underlying assets are held and not actively traded, operating expenses are usually lower than some alternatives.

A Closer Look
For some investors, it is reasonable to assume that all index funds perform the same; however, a deeper look uncovers numerous disparities across fund types.

Perhaps the most distinctive difference -- one guaranteed to eat into your return -- is a fund's operating expenses. These are expressed as a ratio - the percentage of expenses compared to the amount of annual average assets under management:

Example - Expense Ratios
Investors who choose to place their money in index funds should, theoretically, expect lower operating expenses, as the fund manager doesn't have to select or manage any securities whatsoever. In general, expenses are very important to consider when investing. Index funds are no exception because expenses impact an investor's return. Consider the following comparison of 10 S&P 500 funds and their expense ratios as of April 2003:

Figure 1

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%.

Fee Factor
That index funds with almost identical portfolio mixes and investing strategies get away with charging higher fees may seem implausible. However, some index funds charge front-end loads, back-end loads and 12b-1 fees -- which, when taken cumulatively, dramatically impact your return. For example, one fund in the above chart (which will remain unnamed) doesn't have the highest expense ratio but charges a back-end load of 3% and a 12b-1 fee of 1%.

Whatever the reason, no reasonable justification exists for higher fees or operating expenses for the exact same product. Whether a result of greater management experience in tracking indexes or larger firms possessing larger asset bases, enhancing the ability to use economies of scale, larger, more established funds such as the Vanguard 500 Index fund tend to charge lower fees. 

The Tracking Error
Another method for effectively assessing index funds involves comparing their tracking errors and quantifying each fund's deviation from the index it mimics. The tracking error is usually expressed as a standard deviation, so sizable deviations indicate large inconsistencies between the return of an index fund and its benchmark

This large divergence is a general indication of poor fund construction and/or large fund fees and high 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. Deviation creates smaller gains and larger losses for the fund. 

Figure 2 (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.

Figure 2

Source: Barchart.com

What's in a Name?
When screening for an index fund designed to fit your investing needs, do not be misled: Not all index funds labeled "S&P 500" or "Wilshire 5000" only follow those indexes. Some funds actually have divergent management behavior. Within the S&P 500 fund group, there is a socially responsible index fund and an enhanced fund. Both of these funds can be found within the S&P 500 Index Tracker funds category - but are they really index funds?

When a portfolio manager for an index fund performs additional management services, the fund is no longer passive. Consequently, funds with these added selling features have fees well above average.

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!

Figure 3

Seeking buy-in on a fund whose goal is to beat the S&P or to be socially responsible is not a problem. The point here is to avoid confusion, which may arise between true index funds and funds that just have index-like names.

Final Considerations
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 and/or sector funds. Remember that focused funds tend to hold fewer than 30 stocks or assets within the same sector. The lack of diversification in sector funds - like the American Gas Index fund - and value index funds that invest in fewer than 30 stocks - like the Strong Dow 30 Value fund - 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.

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:

Figure 4

In this example, the Orbitex Focus 30 A has an expense ratio of almost 3%. A closer look shows a front-end load of 5.78% and 12b-1 fees of 0.40%. Because the Dow lost around 12% over the year ending at the end of April 2003, investors in this fund would have lost a whopping 15% in return.

Take-Home Notes
If you are an investor seeking index fund investment opportunities, it's important to look beyond the moonshot view:

  1. Costs and tracking errors - Try to choose investments with minimal operating expenses and, preferably, no fees or tracking errors attached. An excellent resource that we've found useful for screening index funds, especially those tracking the S&P 500 index, is Indexfunds.com. This website's screening feature allows you to sort funds according to their expense ratios, returns, and other elements.
  2. Compare your chosen index fund with other similar funds - This allows you to determine reasonable expense and tracking error ranges for particular fund groups.

The Bottom Line
Careful investigation of index funds before buying in involves making sure fees are low, a firm comprehension of what a given fund invests in, as well as strategies and goals managers use to meet objectives. Index funds can be very dependable investments, but investors are more likely to find one they can count on if they weed out any element of surprise.