Today things are different. At the end of September there were 544 index funds that specialize in domestic stocks. There were 678 index funds of all kinds. (The new Exchange Traded Funds are included in this list.) To put those figures in some perspective, the number of index funds available today exceeds the number of mutual funds investors could choose from twenty years ago.
Query: So which index funds do we invest in?
Answer: the funds that retain the most powerful advantages of index funds--- low expense ratios and cost efficient low portfolio turnover. Today, the 544 domestic equity index funds have an average annual expense ratio of 0.76 percent. This may seem reasonable at first glance--- it's nearly half the expense ratio of the average managed fund.
In fact, it's ridiculous to the point of being silly. There are 600 managed funds with lower expense ratios than the current index fund average. Some of those 600 funds have delivered very handsome performances for their management fees. For instance, all four of the American Funds mentioned in my Sunday column have lower annual expense ratios than the average index fund.
Similarly, the annual portfolio turnover rate for the domestic equity index funds averages 95 percent. This isn't far from the 111 percent turnover rate of the average managed fund. As a result, an index investor who doesn't discriminate incurs virtually all the portfolio trading costs---and possible tax consequences--- of the typical managed fund. Bottom line: If you're not careful, you'll get most of the expenses and little of the benefit of index investing.
So what do we do?
We reject high expense or high portfolio turnover index funds and concentrate on the low expense, low turnover funds. Here are some examples of silly index funds.
• Morgan Stanley S&P 500 Index B shares. By selling them as B shares with a hefty 1 percent annual 12b-1 fee, Morgan Stanley has taken the annual expense ratio up to 1.50 percent. Incredibly, the firm has captured just more than $1 billion in assets in this fund.
• AXP Small Company Index B shares. Again, selling as B shares with a high 12b-1 charge brings the annual expense ratio up to a startling 1.72 percent. The American Express sales force has captured $375 million in this sorry excuse for a fund.
• One Group Equity Index B shares. Same story for a 1.35 percent expense ratio and $316 million in assets 'under management.'
• ProFunds Ultra OTC fund. This highly speculative no-load index based fund aims for twice the return of the NASDAQ 100 index. It carries an expense ratio of 1.80 percent and a portfolio turnover rate of 622 percent. It had over $1 billion in assets in 1999 but is now down to about $100 million in assets.
Fortunately there are 32 domestic stock index funds that have annual expenses of less than 0.20 percent and portfolio turnover of less than 10 percent. Here are some good examples:
• Vanguard Total Market Index Fund. This is my personal pick. It has an annual expense ratio of 0.20 percent, a portfolio turnover rate of only 7 percent, and captures the entire small and mid cap stock market as well at the large cap stocks. It also has the advantage of a minus 32 percent of assets potential capital gain exposure.** This is the equivalent of a 6.4 percent potential tax discount on net asset value. It has about $15 billion in assets. Ticker: VTSMX.
• iShares Russell 1000 Index. This exchange-traded fund has an expense ratio of 0.15 percent and a portfolio turnover rate of 9 percent. While it doesn't cover the total stock market, the Russell 1000 index companies represent about 90 percent of all domestic stock market value. It has about $627 million in assets. This fund is a good substitute for the silly index funds mentioned above. Ticker: IWB.
• iShares Russell 1000 Value Index. Another exchange traded fund, it has an expense ratio of 0.20 percent and a portfolio turnover rate of 9 percent. This is a good fund to own if you want to add a value tilt to your portfolio. It has about $875 million in assets. Ticker: IWD.
*Should have a URL to the 11/03/02 column
** Index Funds Carry New Incentives
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