Simple rules for picking the right index fund

Dollars & Sense

October 13, 2002|By Russel Kinnel | Russel Kinnel,MORNINGSTAR.COM

Some news stories on index funds make them sound like a one-decision investment. Once you've decided to invest in index funds, you're done. But there are hundreds of index funds to choose from, and they invest in different asset classes. You've still got your work cut out for you after you've decided to go the index route.

With that in mind, I've prepared a few simple rules to help you pick the right one. Before you start picking a fund though, you should know what asset class you need. This will help shorten the selection process.

Decide whether you're investing a lump sum or will add to your investment.

If you're going to shift a big sum into an index fund and don't plan to add to your investment, an ETF (exchange-traded fund) is probably the way to go. You have to pay a brokerage fee to buy and sell, but the cheapest ETFs have lower expense ratios than the cheapest traditional, open-end funds. If you're going to invest every month or every year, the brokerage costs will probably overwhelm their slight advantage, however.

Get something cheap.

I hope this isn't a surprise. Though the cheapest index funds' costs are lower than those of the cheapest active funds, a wide range of fees is attached to both types of funds. The main point of index funds is that you have lower costs eating away at your returns, so you should be picky about costs.

I wouldn't touch an index fund with an expense ratio above 0.40 percent. Believe it or not, some have expense ratios exceeding 2 percent. Plenty of index funds can be dangerous to your fiscal well-being.

Search for low-turnover funds.

This isn't too important for a bond index fund, but it's crucial for a stock index fund. The reason is that high turnover in an index fund can be murder on trading costs. Trading costs aren't part of the expense ratio, but they can eat away at the fund just the same. An equivalent amount of turnover at a small-cap index fund usually costs more than at an active fund because an index fund has to make incremental investments in stocks that are too small for it to get a good price. Some small-cap index funds with high turnover can end up lagging behind the index they track by two or three percentage points because of trading costs.

Go for broadly diversified funds.

Many ETFs launched in recent years focus on narrow indexes such as the Dow Jones industrial average or the Nasdaq 100. The problem is that concentrated funds can be quite volatile, making it harder to make your asset allocation.

A fund that tracks a broad index such as the S&P 500 is easy to fit into your portfolio. It pretty much covers the whole large-cap universe, but it's tougher to build a portfolio around a concentrated index. Diversified funds also have lower turnover because they aren't throwing out stocks that no longer qualify the way a small-value index fund can.

I like indexes such as the Wilshire 5000 and S&P 500, where stocks aren't thrown out because they get too big.

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