Best Index Funds: Does Vanguard Still Rule The Roost?

On December  31, 1975 John Bogle started the First Index Investment Trust, now known as the Vanguard 500 Index Fund (VFINX).  Widely ridiculed at the time, this mother of all index funds went on to become one of the largest and most popular mutual funds in the history of the industry (and one of the top index funds in terms of risk-adjusted performance, as well).  Since that fateful day, Vanguard has been widely regarded as running best index funds in town, thanks mostly to Vanguard’s investor-friendly commitment to rock-bottom mutual fund expenses.  And as anybody familiar with this blog knows, I’m a big fan of index investing.

But all that has been slowly changing over the last decade.  Where Vanguard index funds were once unquestionably the best index funds money could buy, there are a few new kids on the block with arguably better funds.  Don’t get me wrong, Vanguard is still my mutual fund company of choice, but when it comes to index funds it’s no longer the only game in town.

Note: If you want to do your own index fund comparison, I recommend opening a free Morningstar.com account to gain access to a virtually limitless amount of mutual fund information, good discussion forums, and some really cool portfolio tools such as the Portfolio X-Ray tool which allows you to break down the makeup of your entire consolidated portfolio by industry,  market cap, geographic region, and other useful metrics.  I do most of my mutual fund research on Morningstar and it’s really the only tool you need, in my opinion.

Who Has The Best Index Funds?

Dimensional Fund Advisors

My vote for the top contender for the “best index funds” prize is Dimensional Fund Advisors.  It is important to note that DFA funds don’t track conventional indexes, rather, DFA has its own proprietary method of dividing the market up into investable asset classes.  While this is unlikely to materially affect long-term investment returns, it’s something to keep in mind i.e. the small-cap value Vanguard and DFA funds won’t behave identically since they don’t track the exact same index.

Advantages Over Vanguard:

DFA offers by far the most index funds for the greatest variety of asset classes.  DFA has index funds for small-cap value emerging market funds, for example, while Vanguard has only one Emerging Market Index Fund (VEIEX), which is a large-cap fund.  Small-value tilters will have a much easier time with DFA than with Vanguard in the international arena.  What’s more, Vanguard doesn’t have an international value index fund at all, and the actively-managed fund alternative (VTRIX) suffers from quite a bit of style drift, becoming decidedly “growthy” at times.  DFA has the best index funds in some asset classes by virtue of being the only real option for retail investors.

Disadvantages Relative To Vanguard:

Being a much smaller company, DFA funds are significantly more expensive than comparable Vanguard funds where they go head-to-head.  The kicker, though, is that you can currently only buy DFA funds through a financial advisor associated with the company, which adds considerably to Vanguard’s cost advantage over DFA.  Investors who either don’t want or don’t need professional financial advice are unlikely to get enough value to make up for the additional expense.

Fidelity

Everybody knows Fidelity.  While they specialize in actively-managed funds (which I recommend you avoid), they do offer a small line-up of index funds marketed as the Spartan index funds.

Advantages Over Vanguard:

In what was most likely a direct attempt to steal index fund customers from Vanguard, Fidelity dropped the expense ratios on their Spartan index funds below that of their Vanguard competitors.  The expense advantage is not huge (it varies, but usually in the hundredths-of-a-percent territory), but it is real.

Disadvantages Relative To Vanguard:

While the Spartan index funds are cheaper than their Vanguard brethren, there are four catches.  First, they are only cheaper than the investor share class of the comparable Vanguard index fund.  Vanguard has another share class, called Admiral Shares, that are as cheap or cheaper than their Fidelity competition.  Admiral shares are only available to investor with at least $100,000 in the fund, however (or at least $50,000 if the account is at least 10 years old).   Thus, Fidelity’s cost advantage disappears once your portfolio reaches sufficient size for the small cost differential to actually cost you much in absolute dollar terms.

Second, the low costs of the Fidelity funds are due to a fee waiver by the fund manager.  Currently, Fidelity seems to think it’s worth taking a small loss on the funds if it gets them additional business for their more lucrative actively-managed funds.  This could change at any time, however.

Third, Fidelity Spartan funds have a $10,000 per-fund minimum, which is steep for many investors.  Vanguard, by contrast, has a more-manageable $3,000 fund minimum for their index funds.

Finally, Fidelity has an extremely limited line-up of index funds.  You get the total market index fund, the international developed market index fund, the extended market index fund, and the total bond market index fund.  There is no emerging market index fund, small-cap value index fund, REIT index fund, or any other asset class most investors would want to own.

Charles Schwab

Charles Schwab made its market as a discount brokerage, but has since branched out into the mutual fund business.

Advantages Over Vanguard:

Charles Schwab’s one and only advantage over Vanguard is the rock-bottom expenses of their index funds.

Disadvantages Relative To Vanguard:

Charles Scwhab suffers from many of the same disadvantages as Fidelity:  namely small selection.  It would be possible to create a diversified portfolio with Schwab, but small-value tilting is completely out of the question.

The Verdict

My conclusion will probably come as no surprise to regular readers of this blog.  For most asset classes, Vanguard offers the best index funds, all things considered.  Vanguard isn’t always the cheapest, but it usually is.  And when it’s not the cheapest, it’s not too far behind.  For asset classes Vanguard doesn’t cover, Dimensional Fund Advisors is the clear second choice.  Investors already investing through a financial advisor will probably do well to choose DFA funds whenever a Vanguard option isn’t available.  For the rest of us DIY’ers, most of the asset classes DFA offers that Vanguard doesn’t fall into the “would be nice to have, but not necessary” category.  I’d love to tilt small-value in emerging markets, but is it really necessary to be diversified?  No.  Will the additional benefit of investing in this asset class make up for the additional cost involved?  I don’t know, but I suspect probably not.

It should be noted that practically all Vanguard index funds have an ETF equivalent with even lower expense ratios than their open-ended cousins you can trade for free on the Vanguard Brokerage platform or for a small fee at my favorite discount brokerage, Tradeking.