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Personal Finance > Ask the Expert
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The best index funds
Define 'best' -- index funds are only as good as the indexes they follow.
November 8, 2002: 1:12 PM EST
By Walter Updegrave, CNN/Money Contributing Columnist

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NEW YORK (CNN/Money) - What are the best index funds?

-- Bryan K. Colbert, Springfield, Illinois

You've got to be careful about that word "best." If by best you mean which index funds will give you the highest returns, then I'd have to say I have no idea.

The premise behind index funds is that they track a particular index -- such as the Standard & Poor's 500 index (an index of large-company stocks) or the Russell 2000 (an index of small-company shares) or any of a slew of others -- so that their value goes up and down in line with the index.

If you invest in an index fund pegged to the S&P 500 during a time when large-company stocks are hot and small-cap stocks are out of favor, then an S&P 500 index fund will outperform a Russell 2000 index fund. Does that mean the S&P 500 index fund is better? No, it means the type of stocks it tracks were doing better at that particular time.

Not all index funds are created equal

All that said, however, there are some qualities I think you should look for in an index fund. First, the fund's returns should closely mirror those of the index it's supposed to be tracking. So if a fund is supposed to track the S&P 500 index, you want its returns to mirror the S&P 500's returns as closely as possible.

That may sound obvious. I mean, if the fund is an S&P 500 fund, why wouldn't it track the S&P 500 index? Well, there are a few possibilities. The manager might figure he can juice the fund's return a little bit by perhaps slightly changing the fund's sector weightings (retail, tech, financials, etc.) compared to those of the index.

What could be wrong with shooting for a slightly higher return? Well, the manager might get a slightly lower return instead. And since the whole point of buying an index fund is to get as close to the index return as possible, such tactics defeat the whole purpose of buying an index.

This sort of thing is rare in true index funds, although it's the stock-in-trade of what are known as "enhanced" index funds, or funds that try to generate returns slightly higher than those of the index they follow. Still, index funds do deviate from their indexes from time to time for a variety of reasons.

Some indexes, for example, include so many securities that it's simply impractical for a fund to hold them all. So fund managers may hold a sampling of the securities in the index. In some cases, an index fund's prospectus may allow the manager to tweak the portfolio in other ways.

Recently, Vanguard, the king of indexing in mutual funds, came under fire because the return on its Total Bond Market Index for the year to date through early October had slipped behind the return for its target benchmark, the Lehman Bros. Aggregate Bond index, by almost two percentage points.

That happened as a result of some unusual turmoil in the bond market earlier this year combined with the fact that the fund's manager has some leeway in adhering to the target index's composition, overweighting some areas and underweighting others. Two percentage points may not seem like a big deal, but in the index world that's a Grand Canyon size gap. Vanguard spokesperson Brian Mattes said the fund has taken several steps to tighten its tracking versus the index.

Look for low expenses

But for my money at least, the most important thing to look for in an index fund is low expenses. I mean, if I'm interested in tracking the S&P 500 fund, and one S&P 500 index fund charges 0.18 percent per year (as the Vanguard Index 500 fund does) while another charges 1 percent or more per year (as some two dozen or so funds do), there's no reason to pay the higher amount year after year after year.

I'm not looking for the manager to add value here -- I'm buying an index. And, in fact, the lower the expenses, the more likely the fund will be able to deliver the index return because less of my money will be siphoned off by the fund company.

Fortunately, it's easy to compare expenses on index funds by going to a site such as Morningstar. And while you're at it, don't forget to check out that other breed of index funds known as ETF, or exchange traded funds. These are essentially index funds that trade like stocks. They often have expenses as low or even lower than those on regular index funds, although you'll have to pay brokerage commissions when you buy and sell.

ETFs also have some tax advantages that regular index funds don't have. For more on how to evaluate both regular index funds and ETFs, click here.

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Finally, I think it's important to remember that the way you use index funds is as important as the funds themselves. These days, you can buy index funds that not only track the U.S. stock market overall, but that let you buy small slices of the market, small-cap growth or value stocks, specific industry sectors, even subsectors semiconductor or broadband stocks.

Investing in narrow niches is great if you think you have some insight into which niche is likely to outperform the others. I think such insights are rare. The original premise behind indexing was to give investors who didn't want to make such sector calls or deal with individual stocks a way to buy the market overall.

So as you continue your quest for the "best" index fund, I recommend you also take some time to think about the best way to use index funds. If you come to the same conclusion as I do on that issue, you'll find you've narrowed your search considerably.


Walter Updegrave is a senior editor at MONEY Magazine and is the author of "Investing for the Financially Challenged." He can be seen regularly Monday mornings at 8:40 am on CNNfn.  Top of page




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Most stock quote data provided by BATS. Market indices are shown in real time, except for the DJIA, which is delayed by two minutes. All times are ET. Disclaimer. Morningstar: © 2018 Morningstar, Inc. All Rights Reserved. Factset: FactSet Research Systems Inc. 2018. All rights reserved. Chicago Mercantile Association: Certain market data is the property of Chicago Mercantile Exchange Inc. and its licensors. All rights reserved. Dow Jones: The Dow Jones branded indices are proprietary to and are calculated, distributed and marketed by DJI Opco, a subsidiary of S&P Dow Jones Indices LLC and have been licensed for use to S&P Opco, LLC and CNN. Standard & Poor's and S&P are registered trademarks of Standard & Poor's Financial Services LLC and Dow Jones is a registered trademark of Dow Jones Trademark Holdings LLC. All content of the Dow Jones branded indices © S&P Dow Jones Indices LLC 2018 and/or its affiliates.

Most stock quote data provided by BATS. Market indices are shown in real time, except for the DJIA, which is delayed by two minutes. All times are ET. Disclaimer. Morningstar: © 2018 Morningstar, Inc. All Rights Reserved. Factset: FactSet Research Systems Inc. 2018. All rights reserved. Chicago Mercantile Association: Certain market data is the property of Chicago Mercantile Exchange Inc. and its licensors. All rights reserved. Dow Jones: The Dow Jones branded indices are proprietary to and are calculated, distributed and marketed by DJI Opco, a subsidiary of S&P Dow Jones Indices LLC and have been licensed for use to S&P Opco, LLC and CNN. Standard & Poor's and S&P are registered trademarks of Standard & Poor's Financial Services LLC and Dow Jones is a registered trademark of Dow Jones Trademark Holdings LLC. All content of the Dow Jones branded indices © S&P Dow Jones Indices LLC 2018 and/or its affiliates.