When to Dump Your Index Fund

One of my favorite features in Motley Fool Champion Funds is Shannon Zimmerman's monthly update on exchange-traded funds (ETFs) and index funds. Though I'm a stock investor at heart, I believe almost everyone should have index funds at the core of their portfolios.

But there are some index trackers out there that should be dumped, because they simply don't deserve your hard-earned dollars.

Fees are heading downward
A small revolution is under way in the industry, and it's been very good news for you and me. Vanguard, Fidelity, and some of the other big index fund providers -- perhaps under pressure from low-cost ETFs -- have been lowering the management fees for their products.

Take Fidelity Spartan 500 (FSMKX), for instance. If you have at least $10,000 to invest, you'll now be charged only a minuscule 0.1% expense fee. If that $10,000 is too high of a hurdle, you can start with as little as $500 if you use the "automatic account builder" option, which makes automatic deposits for you on a regular schedule. Another option is the stalwart Vanguard 500 Index (FUND: VFINX  ) , which charges only 0.18% and carries a minimum initial investment of just $3,000.

So those two provide a baseline comparison for any S&P 500 trackers. What about other index offerings? Let's take a look at two mid-cap index funds:

Dreyfus MidCap Index (PESPX)
Top Holdings*
First American Mid Cap Index (FDXAX)
Top Holdings*
Legg Mason (NYSE: LM  ) Legg Mason (NYSE: LM  )
Peabody Energy (NYSE: BTU  ) Peabody Energy (NYSE: BTU  )
SanDisk (Nasdaq: SNDK  ) SanDisk (Nasdaq: SNDK  )
Chico's FAS (NYSE: CHS  ) Whole Foods (Nasdaq: WFMI  )
Expeditors Intl. (Nasdaq: EXPD  ) Chico's FAS (NYSE: CHS  )
Expense ratio: 0.50% Expense ratio: 0.75%
*As of Feb 28, 2006, for Dreyfus. As of Dec. 31, 2005, for First American.

Both funds seek to duplicate the S&P MidCap 400 index, yet First American's expense ratio is a stratospheric 1.5% for its Class B and Class C shares. Its Class A shares charge a still-lofty 0.75%, but you may have to pay up to a 5.5% front load! Dreyfus' 0.5% is much more reasonable, yet even that is high compared with Vanguard's Mid Cap Index (VIMSX), which charges 0.22%. (It tracks a different mid-cap index, but that's still no excuse for Dreyfus and First American.)

If you're an aficionado of small caps, Vanguard's Small Cap Index (NAESX) gives us a good idea of a low expense ratio in that space, charging just 0.23%.

Is it time to dump your index fund?
When it comes to index trackers, you can expect that, on average, your fund will lose to the index by the amount of its expense fees. And while the gap between, say, 0.75% and 0.18% may seem small, it's actually a huge difference that will cost you big money -- hundreds of thousands -- over the years. "With that in mind," Shannon says, "there's simply no reason to pay any more than you absolutely have to for a fund that merely tracks a benchmark."

Check out your index fund's expense ratio to see how it stacks up with competing products. Keep in mind that Vanguard's and Fidelity's low-cost offerings range from 0.1% to 0.23%. If yours is significantly higher, you should definitely consider moving your money into a lower-cost fund that tracks the same index.

More fund fun
The monthly "ETFs & Index Funds" feature in Champion Funds is an interesting read that can profit any index investor. It certainly caused me to scrutinize my index fund's fees.

Shannon is offering a free trial to his newsletter, which will grant you access to every pick he's ever made and every index-fund column. His recommendations are beating the market and equivalent benchmarks 23% to 11%. Try it for free for 30 days, and if you don't like it, it won't cost you a penny.

This article was originally published on Jan. 6, 2006. It has been updated.

Rex Moore indexes in his 401(k). Rex does not own shares of any company mentioned. Whole Foods is a Stock Advisor recommendation. This information is brought to you by the Fool'sdisclosure policy.


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