Sunday, November 29, 2009

What is a low cost index fund?

I started writing these articles as Facebook notes, so am copying those to here.  In a comment to my first investing note (on facebook), someone asked what a low cost index fund is.

An index fund is a mutual fund that attempts to track an index. So, first we have to define mutual fund and index.  Then I'll get into the cost aspects.

Please read on if interested ...

A mutual fund is an organization that owns shares of many different securities; i.e., stocks or bonds (defining stocks and bonds requires another note). When you buy a share of a mutual fund, you are buying some of all the stocks or bonds that the fund owns. This gives the investor a convenient way to diversify among many stocks or bonds.

A stock or bond index is an imaginary collection of stocks or bonds representing a particular market or portion of it. For example, a total US stock market index would represent all publicly traded US stocks. A total international stock market index would represent all publicly traded non-US stocks.

So, an index fund simply attempts to get you the market return by tracking its selected index. By contrast, an actively managed mutual fund employs a manager or team of managers who attempts to beat the market, either by picking stocks they think will outperform the market, or by trying to time the market (buy when they think stocks are cheap, and sell with they think they're expensive). Most academic studies show that using index funds generates superior long term returns. There are many good books I can recommend that go into this in great detail.

Like any organization, all mutual funds have expenses; e.g., management, administration, marketing, distribution, etc. The standard way to measure and compare mutual fund expenses is the expense ratio. Expense ratio is the ratio of a fund's annual expenses to its total assets (the value of all the money it has invested in stocks or bonds). For example, a fund with a 1% expense ratio will charge you 1% of your investment each year. You won't see it on your statement, but your investment return is effectively reduced by this amount. For example, if all the stocks or bonds the mutual fund owns earned 5% in dividends, interest and appreciation in a year, you would receive 4% (sticking with our example of a 1% expense ratio).

For US stock or bond funds, low cost would be less than 0.25% or so. International funds are typically more expensive, but you still find ones that charge a fraction of a percent. I would consider a fund that charges 1% or more outrageously expensive. However, the industry average expense ratio is about 1.2%. This may not sound like a lot, but over many years, considering the compounding effect, it can make a very large difference in how much you end up with.

I usually don't even think about mentioning another kind of expense, because I never even consider buying a mutual fund that charges it. It's referred to as a "load", and it's an additional fee that is charged either when you buy or sell the fund. This fee is basically a commission that goes into the pocket of whoever you buy the fund from.  Some funds charge loads as high as 5-6%. There is absolutely no evidence that justifies paying these kind of fees, when there are so many good no-load funds available.

There are other expenses that aren't included in the expense ratio, like turnover costs, but I won't go into that here. They are important, but if you stick with a good index fund, you won't have to worry much about them.

As to specific examples, here are some of the funds I recommend to get started with, along with their expense ratios.

Vanguard Total Stock Market Index, 0.18%
Vanguard Total International Stock Index, 0.34%
Vanguard Short-Term Investment-Grade Bond Fund, 0.26%
Vanguard Intermediate-Term Investment-Grade Bond Fund, 0.26%

Fidelity Spartan Total Market Index Fund, 0.10%
Fidelity Spartan International Index Fund, 0.20%

Schwab Total Stock Market Index Fund, 0.09%
Schwab International Index Fund, 0.19%

The minimum investment for the Vanguard funds is $3000; for the Fidelity Spartan funds it's $10,000, and for the Schwab funds it's $100.

Although the Vanguard international fund has a higher expense ratio than the Fidelity or Schwab international funds, I prefer it, since it includes emerging markets, and therefore is more of a total international fund. Most advisors I respect recommend including emerging markets in your portfolio, but I won't go into the reasons here.

The Vanguard bond funds listed aren't true index funds, but are "index-like", in that they are low cost, hold a large number of bonds, and have low turnover. If you want to stick with true index funds, Vanguard has good short and intermediate term index bond funds. Currently, I prefer the investment grade bond funds for reasons that I won't get into here.

No comments:

Post a Comment