Look at cost when picking an index fund

Dollars & Sense

November 16, 2003|By MORNINGSTAR.COM

What are the top S&P 500 index funds?

-Lilya H.

Lilya is a woman on a mission: She wants an index fund, and she wants the best.

Index funds that share the same benchmark invest in the same stocks. In theory, then, they should deliver nearly identical returns. There are a couple of factors, however, that can push index funds ahead or drag them behind.

The most important factor separating the best index funds from the worst is cost.

Plain and simple, the index funds with the smallest expense ratios have an automatic advantage over their more expensive counterparts. This puts the supercheap funds such as Vanguard 500 Index (VFINX) (0.18 percent expense ratio), Fidelity Spartan 500 Index (FSMKX) (0.19 percent) and the S&P 500 exchange-traded SPDR Series Trust (SPY) (0.11 percent) at the head of the pack.

Think that costs don't make that much of a difference?

Compare the 10-year annualized returns of Vanguard 500 and BlackRock Index Equity (CIEAX), which has an expense ratio of 0.79 percent for its A shares. Both follow the same approach, but over the past decade, the Vanguard fund has delivered an annualized gain of 9.98 percent while the BlackRock fund has gained 9.19 percent.

The S&P 500 index gained 10.04 percent over the same period. Thus, the Vanguard fund had a much easier time keeping pace with its bogey than the BlackRock offering.

Another factor that determines index-fund superiority is turnover. Index funds with lower turnover usually have an advantage over those with higher turnover. This is because the managers must pay sales commissions every time they trade a stock. Because trading costs aren't included in a fund's expense ratio, estimating their impact can be difficult. However, if you have two funds with identical expense ratios and one has lower turnover, you may want to consider the slower-trading fund.

This advice can be applied across a wide variety of index funds. The cheapest, lowest turnover funds are the best, regardless of which benchmarks they track.

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