Still, what new devotees of indexing may not realize is that just because they’re boring doesn’t mean index funds are insulated from danger. That’s the kind of misconception that could lead you astray if you decide to pursue this sound investment strategy. Here are three myths to avoid:
Index funds are safe. Hardly. Critics of indexing love to point to Japan, a market that’s been in the tank so long it’s forgotten what dry land feels like. The point is that any index that’s supposed to track the Japanese stock market–such as Morgan Stanley’s Pacific and EAFE (for Europe, Australia and Far East) indices–has been dragged down by Japan’s stinky performance. If you’re in an index fund that mimics one of those gauges, you can’t escape. That’s why Pacific index funds summoned average yearly returns of just 7.4 percent for the five years ending in 1995, while actively managed funds logged 9.1 percent. The same thing could happen to your index fund if the U.S. market slumps.
There’s another danger lurking. One reason index funds can operate with such low costs is that they almost never sell their stocks–so you almost never have to pay taxes on stock gains. But if enough fickle indexers begin redeeming their shares, the fund will have to sell. You’ll have to pay taxes, which will hurt your returns.
All index funds are cheap. Don’t fall for this one. All index funds are not cheap, but only cheap index funds are smart for you. Vanguard Index 500, Fidelity U.S. Equity Index, SEI Index S&P 500 Index A and DFA U.S. Large Company have lean expense ratios of between .20 and .25 of a percentage point. That allowed all of them to come within spitting distance of the Standard & Poor’s 500 index’s 16.9 percent return over the last five years–and beat actively managed mutual funds’ average return by at least 2 percentage points. Look at the other end of the spectrum, though. Stagecoach Corporate Stock A and Mainstay Equity index are lugging expense ratios of 1.0 and 1.1 percentage points. Not surprisingly, their returns were lower: 15.6 and 15.3 percent, respectively. Other corners of the index world are where you especially have to watch out for high costs. Retirement System Emerging Growth Equity, which tracks the Lipper Small Company Growth Mutual index, levies a 1.85 percent toll. ASM, a fund that imitates the Dow Jones industrial average, had an extraordinarily high expense ratio of 2.5 percent until last week, when it was lowered to a slender .18 percent.
Cost should be your only criterion. It’s the main thing, but it isn’t everything. Some index funds add a few special twists–such as futures and options–that cause the fund to deviate significantly from its index. Others ““are too small or inefficient to get the best price on their transactions,’’ says Brian Mattes, a Vanguard spokesperson. Look at a year-by-year record of returns showing how closely a fund hews to its chosen index. Remember, the name of the indexing game is predictability. If you’re not getting that, you may as well be trying to pick the next Peter Lynch.
