The choice to use index funds rather than actively managed funds is a significant one, to be sure. And while actively managed funds may come in more varieties in terms of fund characteristics, strategies, and so on, index funds also have their differences, though some are more obvious than others.
Cost Still Counts
Among the biggest differences with index funds is the fees they charge. Funds that are otherwise virtually identical--meaning they track the same index--can nonetheless produce different returns based on their fees. That's because fund fees are deducted from fund returns. So assuming two identical portfolios, the fund with the lower fees, and therefore the smaller bite taken out of returns, will deliver a higher total return to shareholders. (Index funds also may lend out some of their holdings to generate income for the fund and thereby lower their fees.)
To illustrate, let's look at funds that track the most widely used of all indexes, the S&P 500. Morningstar's database includes nearly 50 different mutual funds that track this benchmark (not including the several exchange-traded funds that do so), with expense ratios that run the gamut. Among the cheapest of these S&P 500-trackers are Vanguard 500 Index (VFIAX) and Fidelity Spartan 500 Index (FUSVX), both of which have share classes that cost just 5 basis points (0.05%) per year based on a minimum investment of $10,000. Toward the other end of the spectrum are funds such as Transamerica Partners Stock Index (DSKIX), which tracks the same index but charges 65 basis points--more than 10 times what the cheapest funds charge.
You might think this gap in expense ratios, equaling just 6/10 of one percentage point, doesn't amount to much. After all, what's an extra $60 to pay on a $10,000 investment each year? But this cost difference has an even bigger effect on fund performance when compounded over time. Consider that $10,000 invested in the Transamerica fund 10 years ago would be worth $19,627 today (as of May 31). But the same amount invested in the Vanguard fund (Admiral share class) would be worth $20,808. Same index, same holdings, but the cost difference results in a roughly $1,200 gap in performance during a decade.
The Challenges of Tracking an Index
Although expense ratio is by far the most significant difference among funds tracking the same index, there may be others, as well. Among these are the extent to which the fund tracks its index. For example, the managers of a fund tracking a small-cap index that includes micro-caps--stocks of very small companies that can be hard to buy--may decide it's not cost-effective to try to own each and every stock in the index. Instead they may employ a technique known as sampling, in which the portfolio is designed to mimic the performance of the hard-to-buy stocks, using similarly behaving liquid stocks in their place. Sampling techniques can vary from fund to fund and may contribute to another key index fund difference known as tracking error.
Tracking error is the degree to which an index fund fails to mirror its benchmark's performance during a given time period. Sampling is one source of tracking error. The fund's rebalancing method can be another. As the components and weightings of an index change over time, the fund must buy and sell holdings in an attempt to match it. Let's say a fund's sampling technique results in a slight underweighting in a handful of stocks that are in the index and just happen to have better performance. In that case, the fund's total return may not match that of the index, and the fund will now be even more underweight in those stocks, causing tracking error. In a sense, the fund's expense ratio itself creates a form of tracking error because fees are deducted from returns, though technical discussions of tracking error may exclude the impact of fees.
How can you tell if tracking error is at play with your fund? One way is to check its performance versus the index. The gap between the two should be close to the fund's expense ratio. If it's considerably wider--say, 10 basis points or more--inefficient management may be to blame. Tracking error isn't necessarily a bad thing. In fact, index funds with high tracking error may outperform those with low tracking error. And some indexes are simply more difficult to track than others. But it is generally seen as undesirable based on the assumption that index-fund investors desire indexlike returns.
Subtle Index Differences
Another issue to keep in mind when comparing index funds within the same category is that they may not track the same index. For example, some small-cap blend funds track the Russell 2000; however, Vanguard Small Cap Index (VSMAX) tracks the CRSP US Small Cap Index. The Russell 2000 is more diverse, with 2,000 components to the CRSP index's 1,440, and has more micro-cap exposure. As a result, the average market cap of the CRSP US Small Cap Index is nearly double that of the Russell 2000 at $2.7 billion to $1.4 billion. Other small-blend funds track the S&P SmallCap 600, a more concentrated small-cap index that also has an average market cap of $1.4 billion.
These differences can get even more complex when dealing with funds that track indexes with value or growth tilts. That's because even though blended benchmarks typically include or exclude companies based on their market caps, indexes that focus exclusively on value or growth stocks typically apply their own proprietary screens based on variables such as company fundamentals and stock price. A company that qualifies for one value-oriented index may not qualify for another. Consequently, value- or growth-oriented index funds may have portfolios that vary from one another to a greater extent than one might find among index funds tracking a blended benchmark, especially one that includes highly liquid stocks.
Index funds tend to be rather straightforward, easy-to-own, and cost-effective investment vehicles. By educating yourself about how they differ from one another, you can help make sure they perform as expected.
