Index funds, which track an underlying market index have grown in popularity with investors over the years. A fund might track the S&P 500 or 澳洲幸运5官方开奖结果体彩网:Dow Jones Industrial Average, allowing investors to own each of the holdings within those indices.

Although 澳洲幸运5官方开奖结果体彩网:index funds do attempt to replicate highly similar performance compared to their respective indices, no fund's performance is guaranteed to be the same as similar funds; nor will a fund necessarily replicate the index it tracks. Although the differences between index funds can be subtle, they can have a major impact on an investor's return over the long term.

Undဣerstanding the Hidden Differences Between Index Funds

An index fund is a type of 澳洲幸运5官方开奖结果体彩网:exchange-traded fund (ETF) that contains a basket of stocks or securities that track the components of an existing financial 澳洲幸运5官方开奖结果体彩网:market index. For example, there are index funds that track the Standard & Poor's 500 Index. Although investors can't buy an index per se, they can invest in index funds that are designed to mirror the index. In other words, an index fund tracking the S&P would have all 500 stocks from the S&P 500 in the fund🌼. Index funds tend to provide investors with broad market exposu🍸re or exposure to an overall sector.

As a result, index funds are 澳洲幸运5官方开奖结果体彩网:passive investments, meaning that a portfolio manager is not actively stock-picking by buying and selling securities for the fund. Instead, a 澳洲幸运5官方开奖结果体彩网:fund manager selects a combination of assets for a portfolio intended to mimic an index. Because the fund's 澳洲幸运5官方开奖结果体彩网:underlying assets are held and not actively traded, 澳洲幸运5官方开奖结果体彩网:operating expenses are usually lower than actively managed funds.

At the onset, it might be reasonable that the index fund should track the index with little difference, and other funds tracking the same index should all have the same performance. However, a deeper look uncovers numerous disparities across fund types and 澳洲幸运5官方开奖结果体彩网:helps to uncover some winners.

Expense Ratios

Perhaps the most distinctive hidden difference between index funds is a fund's operating expenses. These are expressed as a ratio, which represents the percentage of expenses compared to the amount of annual average 澳洲幸运5官方开奖结果体彩网:assets under management.

Investors who invest in index funds should, theoretically, expect lower operating expenses since the fund manager doesn't have to select or manage any securities. However, operating expenses can vary between funds. Expenses are very important to consider when investing since expenses can erode an investor's return.

Consider the following comparison of 10 S&P 500 funds and their  as of Nov. 2024:

The different bars in this chart represent different funds. Bear in mind that the 澳洲幸运5官方开奖结果体彩网:average annual return of the S&P 500 as of the start of 2024 was approximately 10%. For🥃 a fund that tracks the index closely, a 1.60% expense ratio will reduce an investor's gains by ab𒉰out 30%.

Fees

Index funds with nearly identical portfolio mixes and investing strategies can have different fee structures. Some index funds charge 澳洲幸运5官方开奖结果体彩网:front-end loads, which are 澳洲幸运5官方开奖结果体彩网:commissions or sales charges applied upfront when the initial purchase of an investment occurs. Other funds charge 澳洲幸运5官方开奖结果体彩网:back-end loads, which are charges and commissions that occur when the investment is sold. Other fees include 澳洲幸运5官方开奖结果体彩网:12b-1 fees, which are annual distribution or marketing fees for the fund. However, the 12b-1 fee can be charged separately or be embedded within the fund's expense ratio.

The fees, along with the expense ratio, should be considered before buying an index fund. Some funds may appear to be a better buy since they might charge a low expense ratio, but they might charge a back-end load or a 12b-1 fee separately. The fees and expense ratio, when taken cumulatively, can dramatically impact an investor's return over time.

Typically, larger, more established funds tend to charge lower fees. For example, the Vanguard 500 Index Admiral Shares fund (VFIAX), which tracks the stocks of 500 of the largest U.S. companies, charges a 0.04% expense ratio as of April 26, 2024.

The lower fees could be the result of management experience in tracking indexes, a larger 澳洲幸运5官方开奖结果体彩网:asset base, which could enhance the ability to use 澳洲幸运5官方开奖结果体彩网:economies of scale in purchasing the securities. Economies of scale are cost savings and advantages re𒁏aped by large companies when they can buy in bulk, thus lowering the per-unit cost.

Tracking Errors

Another method for effectively assessing index funds involves comparing their 澳洲幸运5官方开奖结果体彩网:tracking errors and quantifying🐟 each fund's deviation from the index it mimic♕s.

Tracking error measures how much 澳洲幸运5官方开奖结果体彩网:divergence occurs between the fund's value and that of the index the fund it's tracking. The tracking error is usually expressed as a 澳洲幸运5官方开奖结果体彩网:standard deviation, which shows how much variance or dispersion exists between the fund's price and the average or mean price for the underlying index. Sizable deviations indicate large inconsistencies between the return of an index fund and the 澳洲幸运5官方开奖结果体彩网:benchmark. 

This large divergence could be an indication of poor fund construction, high fees, or operating expenses. High costs can cause the return on an index fund to be significantly lower than the index's return, resulting in a large tracking error. As a result, any deviation can create smaller gains and larger losses for the fund.

The figure below compares the S&P 500's return (red), the Vanguard 500 Index Admiral Shares (green), the Dreyfus S&P 500 (blue), and the Advantus Index 500 B (purple). Notice the index fund's divergence from the benchmark increase as expenses increase.

A Fund's Holdings

Just because a fund says index fund in its name, doesn't necessarily mean it tracks the underlying index or sector exactly. When screening for an index fund, it's important to remember that not all index funds labeled "S&P 500" or "澳洲幸运5官方开奖结果体彩网:Wilshire 5000" only follow those indexes. Some funds can have divergent management behavior. In other words, a por♔tfolio manager may add stocks to the fund that are similar to what's in the index.

Take for example the iShares ESG Screened S&P 500 ETF, which is a socially responsible S&P 500 index fund that avoids companies in controversial business areas. As of Nov. 26, 2024, it had an expense ratio of 0.08%. Another fund, the Rowe U.S. Equity Research ETF, is categorized as an S&P 500 index fund, but it actually seeks to outperform the S&P 500.

Sector index funds that track a sector in the economy are often open to subjectivity by the investment manager as to what's included in the fund. For example, the SPDR S&P Homebuilders exchange-traded fund (XHB) is known for tracking stocks in the homebuilding industry. An investor buying the fund might assume it contains only homebuilders. However, some holdings are stocks of companies related to the industry. For example, Whirlpool Corporation (WHR), the appliance manufacturer, the home supply store, Home Depot (HD), as well as 𓆉Aaron's Inc., w♍hich is a rent-to-own furniture retailer, are all included.

Also, if a 澳洲幸运5官方开奖结果体彩网:portfolio manager for an index fund performs additional management services, the f🌄und is no longer passive. In other words, a fund migh🌸t have the goal to outperform the index, such as the S&P 500, leading to holdings that include companies and securities outside the index being tracked. As a result, funds with these added selling features typically have fees well above average.

It's important for investors to analyze the holdings of an index fund before investing to determine whether it's a true index fund or a fund that has an index-like name.

Lack of Diversification

Within the index 澳洲幸运5官方开奖结果体彩网:fund category, not all funds listed are as diversified as those tracking an index such as the S&P 500. Many index funds have the same properties as focused, value, or 澳洲幸运5官方开奖结果体彩网:sector funds. In general, investors will notice that focused funds tend to hold fewer than 30 stocks or assets, and they may often hold them within the same sector—though there is no specific limitation on the number they can hold. In theory, the lack of 澳洲幸运5官方开奖结果体彩网:diversification in sector funds can expose investors to higher risk than a fund tracking the S&P 500, which is comprised of 500 comp꧙anies within various sectors of the economy.

Special Considerations

Careful investigation of index funds before buying includes making sure that there are little-to-no tracking errors and that fees and expenses ratios are low. Also, it's important to understand the investment manager's goal for the index fund and what holdings or investments are included in order to reach that goal. If the goal is considered aggressive, the fund's investments might deviate from the underlying index.

The need to consider fees becomes even more important relative to increased risk factors—fees reduce the amount of return received for ♏the risks taken. Consider the following comparison of Dow 30 index funds:

An investor's risk tolerance and time horizon can impact the choice of investments. A retiree would likely seek index funds that are conservative or low risk since the goal might be to maintain the portfolio and provide income. A Millennial, on the other hand, might choose a fund that has a more aggressive investment strategy designed to offer growth since the Millennial has more time to make up for any market downturns. Risk tolerance and time horizon are both important considerations when it comes to choosing an index fund.

The Bottom Line

Index funds have become a popular vehicle for retail investors, because they provide broad exposure to a diversified basket of securities. But not all index funds are created equal: Some do a poor job of tracking the underlying index, and others charge high management fees that are not supported by their returns. It is important to research a fund thoroughly to understand what you're getting, and how much it will cost you.