Mar 02, 2020 | Investing

There are tons of index funds. The choice comes down to fees.

If you’ve read my investing advice, you know that over the last 30 years I’ve been saying the wise choice is to go with index funds. And over that same period of ups and downs in the market, these index funds—also known as passively managed funds—have performed as well as or better than actively managed funds, the kind of mutual funds that are overseen by fund managers who pick stocks and charge investors for doing so. That is to say that time and time again, the bold claim of Burton Malkiel from his superb book A Random Walk Down Wall Street has proven true: A blindfolded monkey throwing darts at stock listings would beat the experts at selecting a successful portfolio. What’s more, because index funds don’t charge fees paid to investment managers, their expenses are significantly lower than those of their actively managed counterparts, thus putting more of the return in your pocket. Today, the average actively managed stock fund charges 0.55%, while the lowest-cost index funds (such as those offered by Vanguard, Schwab, and Fidelity) charge 0.04% or less.

That doesn’t mean all index funds are cheap. According to Morningstar, there are more than 450 of them, in nearly 100 different categories. (Plus another 1,820 index ETFs.) Not all them are created equal. While fees are low for index funds overall, they vary significantly from one index fund to the next.

Growing pains

Certain critics argue that index funds are too successful. Three companies—Vanguard, BlackRock, and State Street—command the majority of the index fund market. Together they have more than $15 trillion invested, and they control around 22% of shares in a typical S&P 500 company—including 18% of Apple. This concentration of power has some financial industry watchers worried because more shares means more votes in the boardroom, giving just three companies outsized influence over our biggest corporations—and, by extension, our economy.

The best-laid plans…

For individuals, it’s important to look closely at any expenses before you buy index funds. Even savvy investors can get tripped up and overpay.

Just ask Ken Tumin, the founder of the bank review site DepositAccounts.com, who invested decades ago in an “extended market fund” (also known as a completion fund) to complement his investment in an index fund for big (or “large-cap”) S&P 500 companies. The problem with Tumin’s two-pronged approach? He didn’t check the small print on the completion fund. “I think the annual management fee was around 0.40%,” he said. “The large-cap S&P index fund fee was around half of that.”

It wasn’t until years later that Tumin noticed the fees and consolidated his two funds into a total U.S. stock market index fund. But if an expert like Tumin can get burned, how do ordinary investors avoid sinking limited resources into a lemon—especially when there are now countless options (sold by countless companies) under the index fund label?

How to evaluate an index fund

Here are four key factors to consider when making your choice, with fees chief among them.

1. Expense ratio. Don’t be confused by the word ratio. This is actually a fee—the percentage the company skims off the top each year that includes most of the fees it charges for the privilege of investing with them. As a rule of thumb, stick with an index fund that charges less than 0.1%.
2. Minimum: This is the amount of money you need to open the account, and it can vary widely, from $1 to thousands of dollars. For example, to compare equivalent “total stock market” index funds—the most broad-based kind—across three well-known companies: Schwab and Fidelity have no minimum to invest, while Vanguard requires a $3,000 initial investment. (Note that I am not affiliated with any of these companies.)
3. Turnover: This is the rate at which the fund changes up its investments to match the index it’s tracking—trading some Apple stock here for more Disney stock there, for instance. And that can cut into how much you earn from the fund. “The turnover ratio was about two to four times that of the large-cap S&P,” Tumin said of his expensive fund. “And this was for a brokerage account, so turnover had a big impact on taxes.” Simply put, the higher the turnover rate, the higher the likelihood that a fund will incur capital gains taxes. And those taxes are then passed on to investors. So look for the lowest turnover rate you can find.
4. Sales load: Steer clear of any index fund that charges a sales load, which is basically a commission paid to an intermediary (like an advisor or broker) either upfront or when you sell. Don’t settle for anything but a no-load fund.

Now, let’s do a real-life comparison. To make this as apples-to-apples as I can, I’ve chosen an index fund that invests in every company in the S&P 500 from the three biggest index fund operators.

BlackRock

iShares S&P 500 Index Fund (BSPAX)

• Expense ratio: 0.35%
• Minimum initial investment: $1,000 (though only $50 if you set up automatic investments once a month, quarter, or year)
• Annual turnover rate: 12%  

Vanguard

Vanguard 500 Index Fund Admiral Shares (VFIAX)

• Expense ratio: 0.04%
• Minimum initial investment: $3,000
• Annual turnover rate: 4%

State Street Global Advisors

State Street Equity 500 Index Fund – Class A (SSSVX)

• Expense Ratio: 0.47%
• Minimum initial investment: $2,000 (though only $100 if you set up automatic investments once a month, quarter, or year)
• Annual turnover rate: 12%

As you can see, the differences—especially in terms of expense ratios—can be striking. There is an obvious winner here. Bottom line: Stick with the lowest fees you can find when it comes to index funds.