Choosing an index fund when the indexes are sky-high

Mon Nov 18, 2013 3:28pm EST

Traders work at the Goldman Sachs post that trades IntercontinentalExchange on the floor of the New York Stock Exchange, November 18, 2013. REUTERS/Brendan McDermid

Traders work at the Goldman Sachs post that trades IntercontinentalExchange on the floor of the New York Stock Exchange, November 18, 2013.

Credit: Reuters/Brendan McDermid

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(The opinions expressed here are those of the author, a columnist for Reuters.)

By John Wasik

CHICAGO (Reuters) - When stocks are on a roll - as they have been thus far this year - you want to go big or go home.

Quite naturally, most investors want to take advantage of the market's healthy gains this year. Yet with so many 401(k) offerings and a plethora of stock-index mutual and exchange-traded funds (ETFs) out there, which ones will give you the most bang for your buck?

The answer is surprisingly complicated because there are so many similar options. Many of the best funds are either ignored by investors who insist on owning individual stocks or are not offered in retirement plans. You may have to hunt them down or request that your employer add them.

"Total market" funds are one way to spread your bets. One of the most popular funds is the Vanguard Total Market Index Fund, which is offered through five other share classes, including an ETF. Investors have stashed more than $300 billion in Vanguard's various total-market funds.

This mutual fund (investor shares) samples the entire U.S. stock market, covering the stocks of large, midsize and small companies. Its annual expense ratio is a relatively low 0.15 percent of assets.

As with all total-market funds, there's no need to guess what sector or size of stock is hot at the moment. You get a piece of nearly every listed company. Reflecting the market as a whole, the Vanguard fund is up 37.62 percent for the year through November 15, which beats the smaller subset of Standard & Poor's 500-stock index listings by almost two percentage points, a wide margin in the index-fund business.

But index-fund aficionados are never satisfied. They want to know: Can you cover the entire market in a better way by choosing a different index with a lower cost?

The SPDR Russell 3000 ETF tracks the 3,000 largest U.S. companies, fewer than Vanguard's 3,600 companies. Although different from an open-ended mutual fund, the SPDR fund charges 0.10 percent annually. Vanguard has an ETF version of its total market mutual fund that charges 0.05 percent annually.

While these similar ETFs should move in lockstep - they both track a broad-based total-market index - their performances have not been identical. The SPDR fund is up 36.87 percent for the year through November 15, lagging the Vanguard fund by a 0.75-percentage-point margin.

Over time, this difference widens, with the Vanguard fund holding a 0.85-percentage-point return advantage over the SPDR fund during a five-year annualized period though November 15. That's a two-horse length in the world of index funds.

If you had invested $100,000 over 20 years, earning a 10 percent annual return, you would have paid almost $6,000 in fees in the SPDR fund, compared with about $3,000 for the Vanguard fund, which would have yielded roughly $7,000 more in the total balance at the end of the period, according to the FINRA Fund Analyzer.

The differences are the total expenses and the underlying indexes - or baskets of stocks - chosen to anchor the funds. Vanguard uses an index from the Center for Research in Security Prices, while the SPDR fund uses the Russell 3000 Index.

Both hold more than 70 percent of their portfolios in large companies with an average market capitalization of more than $36 billion. That list includes household names such as Apple, Exxon-Mobil and Microsoft.

"Big index funds and ETFs don't track the same index," says Dan Wiener, chief executive officer of Adviser Investments in Newton, Massachusetts. "Find the cheapest fund tracking the four or five biggest indexes."

CASTING A WIDER NET

Given the recent returns in U.S. markets, it would be easy to focus on U.S. companies to the exclusion of global markets. But don't you want to tap into growth in Africa, Asia, Europe and South America?

For that purpose, a world index is more of a proxy for global growth than a fund that exclusively holds U.S. stocks. The iShares MSCI ACWI Index fund gives you the most popular U.S. stocks plus a sampling of 1,300 companies from across the world. It costs 0.34 percent annually.

If you're concerned about non-U.S. global diversification, the major drawback of the iShares fund is the dominance of American stocks, which are nearly half of the portfolio. But performance-wise, it's still a strong choice - up about 30 percent for the year through November 15 - beating its underlying world-stock index by three percentage points.

You could drive yourself crazy by splitting hairs to find the best indexes and funds. The best way to nail it: Avoid expensive broker-sold index funds and choose ETFs that have no trading commissions.

Since most of the largest fund groups aren't charging ETF brokerage fees for their major index funds, you could own a world of stocks, bonds and real estate funds, all with bargain-basement expense ratios.

(Follow us @ReutersMoney or here; Editing by Lauren Young and Douglas Royalty)

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