Just Ignore the Index Fee War

5 reasons why low expense ratios aren’t the only difference between similar index funds.

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4. Index turnover costs. Most index funds, because they track an index, buy and sell securities on the day the index includes or excludes a company. The problem is that the index's turnover is often announced weeks in advance. Knowing that huge quantities of stock will be bought on a particular day drives both individual investors and large hedge funds and institutions to buy the stock beforehand, which drives the price of the stock up before the date when the change actually happens.

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In one case earlier this year, Samuel Lee of Morningstar wrote, "Standard & Poor's announced that Berkshire Hathaway would be joining the S&P 500. A curious thing happened: Berkshire's stock rocketed to around $76 from $68 in a few short days, a nearly 12 [percent] rise … When the day rolled around, the index funds obeyed their mandates and bought more than $20 billion worth of Berkshire Hathaway stock at a 12 percent premium. It was a $2 billion payday on the index investor's dime."

"For the S&P 500 it is probably a drag, but when you look at a Russell 2000 reconstitution [or "turnover"], it's really significant because you're dealing with smaller-cap stocks," which are more expensive to sell in the first place, says Mindel. How significant? In one of the higher estimates, NYU professor Antti Petajisto predicted that annual reconstitution costs for the small-cap Russell 2000 were between 38 and 77 basis points and between 21 and 28 basis points for the S&P 500. So while these costs lower investor returns significantly more than many low expense ratios, they are difficult to quantify and remain invisible to most investors. Some fund families, such as DFA, reduce index turnover costs by allowing their traders to sell or buy a stock on their own timetable.

5. Expense ratios are not static. What investors have to keep in mind, especially with a fund family like Vanguard that offers flexible expense ratios based on costs, is that expense ratios can rise and fall. According to Vanguard Spokesman John Woerth, the 7 basis points that it offers investors with at least $10,000 in their Vanguard 500 Index fund could rise if costs exceed revenue due to a dip in the market or a large-scale selloff.