Here are some qualities of index funds you’ll want to look at before buying:
Analyze the Tracking Error
The tracking error is a measure of an index fund’s effectiveness in replicating or matching the performance of the benchmark index, which in this case is the S&P 500. One drawback of researching and analyzing this is that mutual fund families do not publicly display the tracking error of their index funds. However, there are a few data points you can research to analyze performance tracking. Research sites such as Morningstar, Lipper, and Kiplinger show how close the historical performance of the fund has been to the target benchmark. If the returns are below the benchmark by roughly the same amount as the fund’s expense ratio, the tracking error is close.
Analyze the Expense Ratio
After looking at the historical performance, take into account the expense ratio. This will tell you how well the fund has tracked the benchmark index in the past. For example, if an S&P 500 index mutual fund has an expense ratio of 0.2%, a five-year annualized return of 10%, and a low tracking error, it might have an annualized return of roughly 9.8%. This means that the only difference between the index and the mutual fund’s return is the fund’s expenses.
Before Investing
Before deciding on an index fund to invest in, be sure to keep in mind other fees, such as trading costs. For example, if you already have an account at Vanguard, you may be charged a transaction fee to purchase a mutual fund like the Schwab S&P 500 Index, which is outside the Vanguard fund family. Typical transaction fees range between $10 and $20. If you are dollar-cost averaging by periodically purchasing shares of your S&P 500 index fund, the expense ratio may be lower, but the trading fees can make the fund more expensive than other options. Here’s a list of some of the cheapest S&P 500 funds you can buy with $1,000 or less: Net Expense Ratio: 0.015% Minimum Initial Investment: $0 Net Expense Ratio: 0.02% Minimum Initial Investment: $0 Net Expense Ratio: 0.16% Minimum Initial Investment: $1,000 Net Expense Ratio: 0.04% Minimum Initial Investment: $3,000 Net Expense Ratio: 0.19% Minimum Initial Investment: $2,500 taxable account, $1,000 IRAs Net Expense Ratio: 0.25% Minimum Initial Investment: $3,000 A difference in fees between 0.01% and 0.03% may not be significant, but differences of 0.05% or more between funds can make a significant difference in your wealth through your working years leading into retirement.
