FOOL'S SCHOOL DAILY Q&A

Index Funds

Q: Are all S&P 500 index funds basically the same? -- B.B., via the Internet

A: In a word: no.

An index fund is a mutual fund that matches the shareholdings of a target index, in this case the Standard & Poor's 500 Composite Stock Price Index (S&P 500). Index funds are different from actively managed mutual funds in that they do not involve any stock picking by supposedly skilled professionals -- they simply seek to replicate the returns of a specific market index. If a company is in the S&P 500 -- which is essentially the 500 largest companies in America -- then it's in an S&P 500 index fund.

When you hear, "The market was up 28 percent in 1998," that means that a particular measurement of the market (in this case the self-same S&P 500) was up 28 percent for the year. Anyone who owned an index fund tracking the S&P 500 during 1998 would also have seen her money grow by basically the same amount. Meanwhile, owners of any of the 88 percent of actively managed mutual funds that underperformed the S&P would have watched their investment fall short of this benchmark. During the 1990s, the S&P 500 has produced an annualized return of 17.3 percent, compared with just 13.9 percent for the average diversified mutual fund. So if an index fund just mirrors the S&P 500, then how can it be that they're not all the same?

In a word: costs.

The idea of index funds was dreamed up by John Bogle, the head of Vanguard Funds. The Vanguard index funds have annual costs of roughly 0.19 percent. Full-price brokerage Morgan Stanley, on the other hand, runs an S&P 500 index fund (buying the exact same stocks as Vanguard's fund) with annual costs of 1.5 percent -- nearly eight times as much! What exactly are you buying for those extra fees? Fools scratch their heads and mutter: "Nothing."

This difference may seem minuscule, but remember that it will compound over time. That is, the first year your initial investment of $1,000 will be lighter by a mere $13 or so. But you then have $13 less earning interest the next year. The same percentage is lost each year, and each year your account holdings grow larger. This is the magic of compound interest, and you want that magic working for you as fully as possible. Over time, percentages become enormously meaningful as they are applied to ever increasing amounts.

There are other differences in index funds too, such as the minimum amount you need to invest (it generally varies between $1,000 and $10,000, but can sometimes be as high as $100,000). There also may or may not be different minimum amounts that you can invest if you want to put an index fund in your IRA. But by far the most important factor in investing is the rate of return, and for that reason you should select an S&P 500 index fund with low annual costs.

WHAT NOW?: Do you have that hankering to see information on index funds laid out just as neatly as your sock drawer? If so then click here. And for more background, see our handy mutual fund area.

Submit a question for Ask the Fool.