Four Important Metrics To Compare Index Funds

Index funds are by far my favorite investment vehicle.  They are passive, cheap, come in practically any asset class you could think of, and most importantly tend to outperform the competition over long periods of time.  Hopefully by now you’re convinced index funds are the way to go, but how exactly do you go about choosing one index fund over another?  After all, there are literally hundreds of different index funds out there, many of them tracking overlapping segments of the market.

Following are four useful metrics to use when comparing competing index funds.

Low Expenses

The single most important attribute to consider when choosing an index fund, and the primary source of their advantage over actively-managed mutual funds, is its expense ratio.  Everything else is secondary.  All else being equal, the index fund with the lowest expense ratio will always outperform other funds tracking the same index by the amount of its cost advantage.  Sadly, there are plenty of expensive index funds out there, so be sure to check before buying.  The quickest and easiest way to check a fund’s expense ratio and other basic characteristics is by signing up for a free Morningstar account and typing the fund’s name or ticker symbol into the search box.

The Index Being Tracked

An index funds will share the investment characteristics of whichever market segment it happens to be tracking.  That is, a small-cap international index fund will perform poorly whenever small-cap international stocks in general are performing poorly, regardless of how large-cap domestic stocks happen to be performing at the time.

There also exist indices constructed in such a way they cost investors money, such as the Russell 2000 index.  The structure of the Russell 2000, for example, encourages large institutional investors to buy and sell at known intervals to take advantage of arbitrage opportunities when securities being added or subtracted from the index, leading investors in Russell 2000 funds to owe larger tax obligations than they otherwise would.  David F. Swensen gives a detailed account of this particular phenomenon in his book Unconventional Success:  A Fundamental Approach To Personal Investment.

Portfolio Turnover

Portfolio turnover is a measure of how often a fund buys and sells securities.  A turnover of 25% means the fund “turns over” approximately 25% of its portfolio every year.  Put another way, it means the fund’s average holding period is about 4 years.  By the same token, a 10% turnover indicates the fund owns the average stock in its portfolio about 10 years.

The higher a fund’s portfolio turnover, the higher its transaction costs in the form of brokerage commissions and the more capital gains are generated (leading to a higher tax bill).  All else being equal, the lower a fund’s portfolio turnover, the lower its total investment expenses (many of which aren’t reflected in the expense ratio figure above).  Portfolio turnover statistics are another benefit available to those with a free Morningstar account.

Reputation Of The Fund Company

Some fund companies are above reproach while others engage in questionable business practices.  More to the point, some fund companies are more likely to raise fund expenses in the future while others are likely to lower them.  Since switching funds in a taxable account involves significant tax costs, it makes sense to keep an eye on the future when making purchase decisions.  Vanguard funds, for example, are likely to be less expensive in the future than they are today because of Vanguard’s unique corporate structure.  Several Vanguard competitors such as Fidelity and Schwab currently have a slight cost advantage over comparable Vanguard funds, however, these for-profit companies are likely operating these funds at a loss in an effort to attract more business to their more profitable actively-managed funds.  What happens when these companies decide it’s no longer worth the effort?  That’s right, you’re stuck in an expensive fund.  So long as the overall current cost difference is minimal, it makes sense to consider the future.