The Skinny on Index Funds
Why indexing works for most investors most of the time—and how it sometimes falls short
(MONEY Magazine) – Index funds are some of the most popular investments going. In the first eight months of 2004, the $97 billion Vanguard 500 Index took in $3 billion in new investments. Pretty good for a fund that does nothing but replicate that well-known market benchmark, Standard & Poor's 500-stock index. And now there's a price war: Fund giant Fidelity recently slashed the annual expenses on its big index funds to 0.10% of assets vs. 0.18% for the Vanguard 500. Why the fuss? Put simply, indexers like Vanguard have whipped the competition. But before you buy the benchmark, there are some important things you should know.
1 It's tough to beat a cheapskate As you can see at right, fund managers have had a hard time beating the S&P 500 over the long run. This isn't because the pros are a bunch of dim bulbs. It's just that they start with a disadvantage: Their expenses take an average of more than a percentage point a year out of returns before they even make a trade. Since index funds simply buy and hold stocks in the index they track, they are much cheaper to run. So Vanguard 500's returns can always match the index within a fraction of a point—close enough to outpace most blue-chip funds. (Why not just buy the funds that do beat the average? The trick is knowing in advance which they'll be.)
NOTE: As of Aug. 31. SOURCE: Morningstar.
2 Many funds are "closet indexers" Another attraction for index funds: Even if you pay extra to get an "active" manager, you may end up owning the same stuff that's in the index. When funds do well and attract more cash from investors, they have to find more stocks to buy—and many eventually end up owning most of the big stocks in the S&P 500 index. Just take a look at what's happened to Robert Stansky's $62 billion Fidelity Magellan, with expenses of 0.70%. It holds about 200 mostly blue-chip stocks and has mostly moved up and down in line with the cheaper Fidelity Spartan 500 Index S&P-tracking fund for a decade—except that it hasn't returned quite as much.
NOTE: As of Aug. 31. SOURCE: Morningstar.
3 They aren't all bargains Even with index funds, you have to pay attention to price tags. A study last year by the Consumer Federation of America and Fund Democracy noted that the average S&P 500 index fund (excluding Vanguard's) charges 0.82%—more than even some topnotch active funds charge. These nickels and dimes add up over time. Consider what would have happened if you had put $20,000 into the class-A shares of Morgan Stanley S&P 500 Index at their inception in 1997. The fund charges 0.70%—and that's not counting its up-front sales load. You'd give up about $1,100 vs. the nearly identical fund from Vanguard.
Value of $20,00 insested in October 1997
Morgan Stanley S&P 500 Index $24,620
Expense ratio: 0.7%
Vanguard 500 Index $25,720
Expense ratio: 0.18%
4 The S&P 500 isn't everything People often think of the S&P 500 as "the market." Actually it represents 77% of the value of all U.S. stocks. Roughly 4,500 smaller companies remain, and they may perform quite differently from blue chips. Vanguard Total Stock Market Index tracks the Dow Jones Wilshire 5000, which includes small-caps as well as the giants of the S&P. That's helped it beat Vanguard 500 by an annualized 1.2 percentage points over the past five years. Exposure to small-caps won't always be such a plus. But if you want maximum diversification from a single fund, a Wilshire 5000 fund is a good bet.
S&P 500 as a percentage of the total market
By market value 77%
By number stocks 9.8%
NOTE: Total market represented by Dow Jones Wilshire 5000 index. SOURCE: Wilshire Associates.
5 Indexing can be risky too Unlike some active fund managers, indexers don't try to juice returns by making big bets on a few stocks. But that doesn't mean index funds can't get drawn into manias. On the S&P 500, companies automatically take up a bigger portion of the index as their market value increases. In other words, the more popular a stock is, the more an index fund owns of it. So around the time the tech and telecom bubble burst in 2000, Vanguard 500 had 39% of its assets in such stocks. (That stake fell to 16% near the market's bottom.) The fund lost a total of 37% from 2000 through 2002. Bottom line: An index fund is no safer than the assets it follows.
Vanguard 500's stake in tech and telecom
March 2000 39%
September 2002 16%
6 Small-caps are complicated Over the past decade, Vanguard Small Cap Index has lagged about two-thirds of small-cap funds. Why? Some argue that it's easier for small-cap managers to outsmart the market, since the stocks they buy aren't widely followed. But part of the problem may have been more technical—for one thing, traders could guess which stocks would be kicked out of the small-cap index, and they sold them ahead of the index funds. To try to improve this fund's numbers, Vanguard last year switched to a different index with less predictable turnover.
How many of their rivals do they beat?
Vanguard 500 Index vs. large-cap funds 79%
Vanguard small cap index vs. small-cap funds 34%
NOTE: As of Aug. 31. Comparison using one share class per fund. SOURCE: Morningstar.