All Index Funds are Not Created Equal

Index investing is relatively simple – certainly much simpler than pouring over meaningless track records, performance statistics and manager biographies of actively managed mutual funds in an attempt to beat the market.  That said, more thought should go into a passive portfolio than buying the nearest S&P 500 fund and considering your work done.

First of all, a passive strategy most certainly does not mean foregoing a well diversified portfolio and all investors should consider their financial goals and risk tolerance when building their portfolios. As Rick Ferri recently acknowledged, there is no such thing as truly “passive” investing: we all have investment decisions that must be made.  When it comes time to select individual funds or ETFs for a portfolio, investors should consider certain criteria to make the best possible long-term selection: overall expenses, portfolio turnover, index composition and investment company reputation.

Let’s take, for example, exposure to large cap US stocks.  The knee-jerk reaction would be to simply buy an S&P 500 ETF such as the widely traded SPY from State Street or Vanguard’s VOO. A simple decision to compare expense ratios of these two funds (0.09% and 0.05%, respectively) might be all you would look at to make a decision. Expense ratios are generally easy to find and compare, but may not necessarily reflect all costs.

The S&P 500 is considered to be a broad representation of US large company stocks, but many do not realize that it is not necessarily the largest 500 US companies.  In fact, the index makeup is decided by a committee at Standard & Poors and the makeup changes annually.  Each year “managers” of all S&P 500 index funds and ETFs must change the makeup of their portfolios to meet the new index, creating trading costs, losses due to bid/ask spreads and possible tax costs. This activity can create some large fluctuations in the prices of stocks moving in and out of the benchmark.

Portfolio turnover is activity that creates a drag on investment returns. Tightly controlled benchmarks such as the S&P 500 will require investors to suffer through higher turnover than a broader and more flexible benchmark will allow. This year, the widely-followed Dow Jones Industrial Average replaced three of the 30 names in the index – 10% turnover for the year!

Investors should look for an index fund or ETF with very broad exposure (more stocks > less stocks) and low annual turnover rates to reduce the drag brought on by these costs.

Lastly, consideration should be given to the reputation and interests of the company offering a product.  The overwhelming majority of mutual fund companies have an obligation to deliver profits to their shareholders, be they public or private.  iShares, for example, is owned by Blackrock, a publicly traded company.  Dimensional Funds is a privately held company with shareholders who expect an annual profit.  Only (to my knowledge) Vanguard has a unique structure wherein the mutual fund investors are also the company owners.  Vanguard (the company) is owned fully by Vanguard’s mutual funds (including ETFs).  Any “profits” that they company may earn are returned to shareholders via lower annual expenses.  While this may not be the sole factor when selecting an investment, it may tip the scales when the decision is otherwise a toss-up.

Tread carefully out there, and make informed decisions.

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