Ask the Expert The best index funds Nov 8 2002

Post on: 22 Октябрь, 2015 No Comment

Ask the Expert The best index funds Nov 8 2002

By Walter Updegrave. CNN/Money Contributing Columnist

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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