NEW YORK (CNN/Money) - I am thinking of buying an S&P 500 index fund. Aren't they all the same and, if so, shouldn't I just buy the one with the lowest costs?
-- Richard, Seattle, Wash.
Oh, I'm sure that the different fund companies that manage index funds pegged to the Standard & Poor's 500-stock index could come up with all sorts of reasons why their fund is managed somewhat differently and performs a whole lot better than the S&P 500 fund run by their competitors. And perhaps there are some fund companies that are more adept at doing certain things, like lending the securities in their fund to gain a smidgen of extra return or trading more adroitly to keep the tracking error between the fund's portfolio and the index at a minimum.
But in the final analysis, to turn poet Gertrude Stein's observations about roses to index funds, an S&P 500 fund is an S&P 500 fund is an S&P 500 fund. Which is to say I don't think there are enough material differences in the way the funds operate for that to be a deciding factor in choosing one.
Given that, I would agree that cost is probably the most important factor in choosing an S&P 500 fund and that you should stick to funds with the lowest expense ratios. I'm not saying you've got to be a maniac about index fund expenses. The Vanguard Index 500 has one of the lowest annual expense ratios around at 0.18 percent of assets, but if you pay a bit more than that I wouldn't be too concerned. On the other hand, I have a hard time understanding why some investors pay upwards of 0.40 percent or more for the S&P 500 funds offered by some fund companies.
Check out the ETFs
One possible exception to this "they're all the same" rule is the relatively new breed of index funds known as Exchange Traded Funds, or ETFs, which are managed by companies like Barclays Global investors (which runs an S&P 500 "iShares" index portfolio) and State Street Global Advisors (which runs an S&P 500 "SPDR," or "spider" as it's better known).
These funds, which trade like stocks, have a unique way of creating shares for new investors and redeeming shares for departing shareholders that has some tax advantages over traditional mutual fund index portfolios. When a shareholder in a regular index fund redeems his or her shares, the fund manager must sell fund securities, which can create a taxable gain that must be passed on to the fund's shareholders. But ETFs have a system that allows the manager to pay departing shareholders without creating taxable gains. As a result, ETFs can be slightly more "tax efficient" than conventional index funds -- that is, shareholders can end up with slightly higher after-tax returns (although superior after-tax performance is not guaranteed).
This small tax advantage, plus the fact that many ETFs also have low expenses -- the iShares S&P 500 has an expense ratio of 0.09 percent, while the SPDR's is 0.12 percent -- makes these portfolios attractive to many index fans. Remember, though, since ETFs trade like stocks, you must also pay a brokerage commission when buying and selling them. So if you're investing, say, $1,000 in an iShares S&P 500 portfolio and pay a $20 fee to buy the fund, you've just added two percentage points in expenses ($20 divided by $1,000). And we haven't even figured in the commission you'll pay when you sell. So unless you're investing some pretty big bucks -- say, $20,000 or more each purchase -- you're probably better off sticking to a low-cost garden-variety S&P 500 index fund.