Excerpted from Common Sense on Mutual Funds by John C. Bogle, pages 133-136
In this analysis of market indexes and index mutual funds, I have had to rely largely on the records of the original two index funds simply because, as the pioneers in the field, they are the funds with the longest records (23 years for the Vanguard 500 Index Fund, and seven years for the Total Stock Market Index Fund). But a caution is necessary: Both of these index funds are large; both are free of sales loads; both have operated at rock-bottom cost; both have maintained low portfolio turnover; and both have been administered with extraordinary efficiency, enabling them to track their target indexes with considerable precision.
The same cannot be said about all of the index funds that are now available in the marketplace. Of some 140 index funds, about 55 are modeled on the S&P 500 Index; four on the Wilshire 5000 Index; 46 on sub-sets of the overall U.S. stock market (large-cap growth and value, small-cap growth and value, and so on); 18 on international markets; and just 20 on the U.S. bond market. Instead of blindly choosing an index fund, investors must be careful to determine that the fund they select is indexed to the market segment they wish to emulate.
Surprisingly, one-third of all index funds carry either front-end or asset-based sales charges. Why an investor would opt to pay a commission on an index fund when a substantially identical fund is available without a commission remains a mystery. The investor who does so starts out on day one by falling as much as 5 percent or more behind the target index - behind the eight-ball, as it were - and falls further behind each year, as fund expenses take their toll. Suffice it to say that it would be silly for an intelligent investor to select an index fund that carries a commission.
It is equally nonsensical to select a fund that carries a high operating cost. Annual expense ratios of index mutual funds run from as low as a nominal 0.02 percent for funds available to very large institutional investors and 0.18 percent for publicly available funds, to as high as 0.95 percent, the rate charged by at least one established fund. That is simply too much to pay. (When a representative of that fund was asked how such a confiscatory fee could be justified, he responded, It's a cash cow - for the manager. Indeed it is. But a cash cow for the investor is a better option.)
Further, beware of the many funds that attest that their expense ratios are low, stating only in the fine print that fees are being waived for a temporary period or until a specific future date. What, really, is the point in your paying an artificially low expense ratio of, say, 0.19 percent for a few years, after which a much higher 0.50 percent fee may be assessed? It is at least possible that, by that time, your investment will have appreciated in value, and you will be subject to capital gains taxes that outweigh the obvious advantage of shifting to a truly low-cost fund. Be sure to read all the fine print about costs in the advertisements, and pay careful heed to the details in the fund's prospectus.
Next, there is the question of portfolio turnover. One of the great advantages of index funds is their tax efficiency. But some index funds, either because of constant heavy investor activity, or because of portfolio strategies based on the aggressive use of index futures, generate high portfolio turnover - sometimes as much as 100 percent or more - and consequently realize and distribute substantial capital gains. When tax-efficient index funds abound, there is simply no reason for taxable investors to select index funds that are tax-inefficient.
Further, all index funds are not created equal in operating efficiency. Some index fund managers, whether by virtue of skill, experience, or dedication, simply do a better job than others in the execution of portfolio transactions. Taking 1996 through 1998 as an example, the best managers of the Standard & Poor's 500 Index funds were actually able to outpace the returns of the index itself by as much as 1/10 of 1 percent annually before the deductions of operating costs; the least successful managers fell 3/10 of 1 percent (or more) behind. This difference in ability to match the index is pretty much ignored by the marketplace. But is should not be. Of what value is a manager, for example, who brags about an expense ratio (often temporary) of 0.18 percent and loses 0.30 percent in operating margin, resulting in a net shortfall of 0.48 percent to the index? Compare those results to the performance of a manager who charges 0.28 percent and exactly matches the index return, for a net shortfall of 0.20 percent. Investors should carefully examine the aspects of each manager's implementation of strategy for any index fund that is being considered.
Finally, index funds vary in the amount of unrealized capital gains in their portfolios. In the abstract, those with modest appreciation (or even losses) on their books might be favored over those with very large appreciation. But this factor should be weighed only in light of the countervailing advantages the funds may offer, as well as their susceptibility to heavy redemptions, their election of redemption-in-kind policies (thus obviating the need to liquidate portfolio securities), and their tax management strategies.
YAHOO! FINANCE TIP
Yahoo! Finance reports a mutual fund's cost, turnover and capital gains data on its profile page. For an example, see VFINX's profile page.
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None of these little percentages may seem like much, but they can represent the difference between day and night for the long-term index fund investor. Even tiny differences in returns truly matter in a lifetime investment program. Consider the different approaches to index fund selection, given in Table 5.3. After a decade, $10,000 in the no-load, low-cost, efficient index fund would have grown to $30,500; in the worst outcome, the load, high-cost, inefficient fund would have grown to $26,500.
