Index funds are mutual funds or exchange-traded funds (ETF) that are composed of stocks or other assets that are tracked by a particular index, such as the S&P 500, and the percentage of each asset in the fund is usually proportional to the weight of that asset in the index so that the fund accurately tracks the index. Index funds are considered a good investment because few funds beat the indexes, and fees are minimal since trading, and its cost, is restricted to tracking the index.
However, index funds usually lag the index by what is known as the tracking error. The returns of index funds are less than what the index would indicate because of fund expenses, including the cost of buying and selling assets to maintain parity between the fund and the index. For instance, since its inception, the iShare S&P 500 Index Fund (IVV) has lagged the S&P 500 Stock Index by a mere 0.06% (as of 12/31/2009).
Some funds minimize these trading costs by buying only the most liquid assets of the index — hence, part of the tracking error comes from not including the less liquid assets in the fund. Liquidity costs, which are equal to the bid/ask spread, also creates a larger tracking error for funds of smaller indexes that are composed of illiquid assets compared to funds that track a popular index, such as the S&P 500 or the Dow Jones Industrial Average, whose underlying assets are traded frequently, with narrower bid/ask spreads.
Nowadays, there are indexes to cover virtually every asset class. Some asset classes are covered by several indexes, and there may be multiple funds covering each index. Hence, not only can an investor choose to follow an asset class, but can also choose the index that tracks that asset, and choose the fund that follows that index.
For instance, 3 ETFs that cover small-cap growth companies include:
- iShares S&P SmallCap 600 Growth (IJT) tracks the S&P Small Cap 600/Citigroup Growth Index;
- SPDR Dow Jones Wilshire Small Cap Growth (DSG) tracks the Dow Jones Small Cap Growth Total Stock Market Index;
- and Vanguard Small-Cap Growth (VBK) tracks the MSCI U.S. Small Cap Growth Index.
As you can see from the following graph, which compares the 2009 returns for the 3 funds, it pays to compare the different funds:
Hence, to maximize investment returns with index funds:
- Pick the asset classes that you think will do best over your investment horizon;
- ascertain which indexes have had the best returns for your chosen asset classes;
- then find the funds with the lowest tracking error for those indexes.
The Internet makes it easy to find and compare different funds for different asset classes. For instance, checking a particular fund at Google Finance, such as the S&P SmallCap 600 Growth Fund, will list other funds covering the same asset class, under its Related Companies section.