Not Every Index Fund Is Created Equal

As with any new product that has a significant impact on financial markets the introduction of the mutual fund in 1924 gave the small investor access to invest in the stock market and changed the face of investing forever. This opened up a business opportunity for financial institutions to create, market and sell a huge range of pension, savings, life assurance and investment products. There followed decades of claims by victims of abusive marketing and sales techniques as producers and financial institutions sought to enhance their profits at the expense of the investors.

This pattern has been repeated in recent decades with the introduction of index funds, and now the development of exchange traded funds (ETFs) which, unlike a traditional index mutual fund, enables an index to be traded like a share in real time on the stock market.

Investors need to be very careful when selecting index funds for their portfolios to avoid being misled by marketing and sales hyperbole. The whole point of indexing is to accept the market rate of return at the market risk for the lowest possible cost. As some 80% of equity managers will fail to beat the market index by on average the amount of their fees and charges (Standard & Poor’s SPIVA Report 2018) by not using an active mutual fund manager, the performance of return on your investment must be in the top 20% of all mutual funds’ performance.

However, this is predicated on the fact that you will receive the market return less costs. It is therefore essential that costs are as low as possible and the fund ‘tracks’ the index as closely as possible. Although index-based portfolios from providers are substantially identical, their costs and tracking of the index is anything but. Total expense ratios range from a miniscule 0.3% pa to what beggars belief at 0.66% pa with an additional subscription charge in excess of 1%. The gap between the expense ratios of the 10 lowest cost funds and highest cost funds for the S&P 500 US Index is 1.3% of assets per year. Do the maths and calculate the capital you are losing over 5, 10 and 15 years!

Today there are some 40 traditional index mutual funds designed to track the US S&P 500 Index 14 of which carry an initial subscription charge of between 1.5% and 5.75%. These costs directly relate to the returns delivered to shareholders of those funds, not the investors in the funds! At the start of 2017 an investment of $10,000 in the Vanguard S&P 500 Index Fund in 1984 grew to $294,000 as compared with the Wells Fargo Equity Index Fund which grew to $232,100. All index funds are not created equal. The wise investor will select only from broad based index funds with deep pools of liquidity at a very low cost with no initial subscription charge and with a low tracking error; provided preferably through a not-for-profit company.

Jeremy Blatch TEP
Society of Trust and Estate Practitioners Logo

This article was also published in the online and print editions of the Sur in English