Not All Index Funds are Created Equal

When picking an index fund or ETF, always check fees and the quality of the fund's benchmark.

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Roger Wohlner

When I first became a financial adviser, choosing an index mutual fund was easy simply because there were so few of them. While many exchanged-traded funds are relatively new, some, like the the SPDR S&P 500 ETF, recently turned 20. For most of the early wave of ETFs, the funds were index products that tracked pretty standard domestic and international equity and fixed income benchmarks.

Fast forward to today. Index products, especially in the ETF arena, are proliferating. Investors have gotten the message about the benefits of indexing, which can include low expenses and adherence to a specific investing objective. Many studies have shown that relatively few actively managed funds actually beat their benchmarks on a consistent basis.

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Unsurprisingly, ETFs have grown in popularity, especially in the wake of the most recent financial crises of 2008-2009. At the same time, ETF providers began offering new products to satisfy the investing public’s demand. Over the past several years many new index ETFs have come to market, and increasingly many are based on questionable benchmarks with only back-tested “history” to give investors a hint at the previous performance of the indexes that underpin these new funds. With lots of new and untested funds on the market, it’s worth developing a strategy to analyze ETFs you’re considering for your portfolio.

When choosing an index fund remember to keep an eye on a few things including:

Watch expenses. Indexing is passive by definition you are simply trying to earn a return that replicates the fund’s underlying benchmark. Cheap is good here.

Consider these two mid-cap funds: The Vanguard Mid Cap Index carries an expense ratio of 0.24 for the “standard” investor share class, but lower cost shares classes of the same fund are also available to shareholders with more to invest or access to a version of the fund via their retirement plan.

At the other end of the scale is Pro Funds Mid Cap fund with an expense ratio of 1.85 percent.

What’s the impact of this difference in expense ratios? Over the 10 years ending May 7, 2013, the Vanguard fund’s average annual return was 11.14 percent versus 9.37 percent for the Pro Funds fund. An investment of $10,000 in the Vanguard fund would have grown to $28,762; an investment in the Pro Shares fund would have grown to $24,482 a difference of over 17 percent in favor of Vanguard. Expenses matter.

Watch benchmarks (especially if an ETF tracks a “non-standard” one). With the proliferation of new index products, especially in the ETF arena, make sure that you understand the underlying index. The traditional use of index products was to get market-like returns via standard benchmarks like the S&P 500 index and the Russell 3000 index. Many newer ETF index products use benchmarks with little or no actual history. Some of this may well be quite good, but if you're considering such a product you need to understand the underlying benchmark before investing.

For example, the PowerShares Dynamic Large Cap Growth fund is a large growth ETF that tracks the Dynamic Large Cap Growth Intellidex index. I’m not at all familiar with this benchmark, or whether it's good or bad. However the fund carries an expense ratio of 0.61 percent which seems pricey to me for an index product.

Again, Vanguard offers an alternative in this asset class, the Vanguard Growth ETF, with an expense ratio of 0.10 percent. Over the previous five years the fund has outperformed the PowerShares product by an average of 1.27 percent annually. In fairness, the PowerShares product has done better than the Vanguard ETF over the trailing three years by an average of 0.74 percent per year. 

But such differences highlight the need for research. The questions you need to ask as an investor include:

  • Will paying the added expense ratio pay off for me in the long run? 
  • Will this index prove to be a viable benchmark over the long haul and will an ETF that tracks it add value over an ETF that tracks a more conventional index?
  • Index funds and ETFs can be a solid low-cost investing tool for all or part of your portfolio. However, like most everything else in the investing world, even indexing has become more complex. You really need to look hard at any index products you might be considering to be sure that the fund is right for your situation and offers the least expensive way to track its benchmark or investing style.

    Roger Wohlner, CFP®, is a fee-only financial adviser at Asset Strategy Consultants based in Arlington Heights, Ill., where he provides financial planning and investment advice to individual clients, 401(k) plan sponsors and participants, foundations, and endowments. Roger is active on both Twitter (@rwohlner) and LinkedIn. Check out Roger's popular blog The Chicago Financial Planner where he writes about issues concerning financial planning, investments, and retirement plans.