Beyond The S&P 500 Index Fund

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Four years ago, before indexing was cool, The Motley Fool was telling anyone who would listen that we agreed with John Bogle -- that indexing was the way to go with mutual funds. For the most part, during that time the Fool has limited its discussion to the S&P 500 index funds, but it's high time to expand the whole definition of index funds just a little bit.

When you hear, "The market was up 28% in 1998," that means that a particular measurement of the market, in this case the Standard & Poor's 500 Index, was up 28% for the year. Anyone who owned an index fund tracking the S&P 500 during 1998 would also have seen their money grow by basically the same amount. Meanwhile, owners of any of the 88% of actively managed mutual funds that underperformed the S&P would have watched their investment fall short of this benchmark.

But do all index funds just track the S&P 500? Oh no -- if you can name a measurement or index of the market, then somebody probably has an index fund for it. The Russell 2000 (an index of 2000 smaller company stocks), the Wilshire 5000 (the entire stock market -- in reality there are about 9000 publicly traded companies but "the Wilshire 8934" just wouldn't sound too good), the Dow Jones Industrial Average ... just to name a couple of the big ones that we talk about in more detail in our Index Center. The list of different indices that are tracked by mutual funds is getting longer all the time.

And we like them all. Almost.

Different indices will produce different results over the short term, but various ivory tower academic studies show that different sectors of the market have more or less produced the same results over longer periods of time. For example, in 1998 the S&P 500, which indexes the largest companies in America, returned 28%, the S&P MidCap 400 (which tracks medium-sized companies) returned 9% less. However, over the last 10 years, the S&P 500 has returned 19.20% annually, and the S&P MidCap 400 has returned 19.28%. Pretty darn close.

Often it takes longer for the averages to even out like that. The Russell 2000, the best-known small company (or "small cap") index, has returned an average of 12.92% over the last 10 years. Does that mean small caps can't keep up with the bigger companies, or that a small cap index fund should be avoided? Not if you look at the longer term. Over the last 40 or 60 years, the returns of the biggest and smallest companies are nearly identical.

But watch carefully what some companies are selling as "index funds." The real point of investing in index funds is not to try to pick the "hot" index, or to pick the "cold" index before it gets hot. Putting your money into an index fund -- any index fund -- delivers great results to the long-term shareholder mainly because index funds keep costs so low. The Vanguard index funds have annual costs of roughly 0.19%. 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% -- nearly eight times as much!

The Motley Fool Index Center offers detailed descriptions of some of the major indexes that have funds that mimic their performance. For more on the wide variety of index funds out there, Index Funds Online has a very good compilation of the funds tracking various indices.