Diversification Benefits Come with Index Funds But Are They the Same?
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For the beginning investor or the employee that must make investment choices for his “401K” contributions, the recommended advice is always to gather knowledge as best you can from reading articles and enrolling in classes to finding a mentor that will help guide your every step in the process. Investing is all about controlling risk and reaping positive gains over time. Diversification is the tried and true process for spreading your investment risk across many investment vehicles, thereby attending to the old adage of “never putting all of your eggs in one basket.”
Where there is an obvious need, one can always count on the market to provide a ready solution. The need for diversification, at least for the individual investor, has been addressed for years through the creation of mutual funds and more recently by the use of Exchange-Traded Funds (“ETF’s”). These funds take the headache out of investing by investing in many companies, and then allowing the buyer to purchase units or shares in the managed commingled fund. Fund managers charge a fee for the service, and investors benefit from diversification and the expertise of the fund manager.
Fund managers have not had a great deal of success over the past decade, one racked by two severe business cycles and the emergence of favorable growth statistics in newly developing economies. These managers have not posted the returns to match their high fees, leading many investors to select so-called index funds to ride the apparent waves in the stock market. Index funds are defined to be, “A type of mutual fund with a portfolio constructed to match or track the components of a market index, such as the Standard & Poor's 500 Index (“S&P 500”).”
If investing in an S&P 500 index fund is a smart thing to do, are some funds better than others? Believe it or not, the correct answer is an unequivocal “Yes”. Since each S&P 500 index fund manager is trying to replicate ownership in entities in the group according to defined formulas, there are not many reasons why his respective performance should vary widely from the actual index itself. The timing of receipts, disbursements, purchases, and liquidations can cause small differences, and the need for cash-on-hand can account for a few more. However, the largest differentiating factor is the amount of management fees charged to the fund.
Typically, these management fees are below 0.50% of the holdings per year, and the better funds are significantly below this level. The more expensive funds tend to be used or recommended by insurance companies. Fees charged might be 2% or more, notoriously high, but necessary to support commission compensation structures in the industry. The lower fees relate to more popular alternatives like the “SPDR’s”, the ETF (“SPY”) run by State Street Global Advisors, or the “Vanguard 500”, an index mutual fund offered by the Vanguard brokerage firm. Each has a track record over five years that is only 1% below the actual index performance.
The best offering on the market today is the “Thrift Savings C Fund”. This fund is part of the Thrift Savings Plan available to United States civil service and uniformed service employees and retirees. Administrative fees are low, and for the past five years, the fund was actually a few basis points better than the actual index performance.
An index fund can provide “broad market exposure, low operating expenses, and low portfolio turnover”, but remember to review how fees are assessed by reading the “small print” in the fund prospectus before making your final choice.
