Not All Index Funds are Created Equal

As readers of this blog know we believe that markets are generally efficient and any time they’re not we accept that we won’t be the ones to exploit such inefficiencies. Readers further know that our choice of investment vehicles for both our clients’ and our money is index funds.

But that doesn’t mean that just any old fund will do. Even index funds can be different and by that we mean the expenses they charge.

Generally, an index fund at least in theory should charge significantly less than its active fund counterpart. The reason being is that index fund manager really isn’t actively managing anything. They’re simply replicating whatever index they are supposed to be replicating according to the fund’s parameters.

So a person may logically think that all index funds should charge roughly the same expenses. But that isn’t the case. Take for example the well-known Vanguard S&P 500 Index Fund charging just .05% for expenses. A similar fund by State Farm charges .75% in expenses in addition to a 5% load (commission). The Rydex S&P 500 Fund charges 1.57% in expenses with an additional 4.75% load (commission).

Generally an index fund’s objective will be to mirror the returns of the index before fees and expenses. The paragraph above explains what happens to investors’ return after fees and expenses are paid. The result is a return far different than what the index did Disclosure: this also includes any fees deducted by fee-only advisors – such as our firm. But the same adage is true: generally the lower the fees and expenses, the better for your returns.

Even Morningstar says that fees and expenses are important considerations in looking at return. Finally, Morningstar has an excellent glossary of terms to help investors understand what many of the terms tied to fees and expenses mean.

If you’re a proponent of index funds that’s good; now, be a proponent of cheap index funds.