X Marks the Index Fund Spot[Fool on the Hill] February 15, 2000

An Investment Opinion

X Marks the Index Fund Spot

By Rick Aristotle Munarriz (TMF Edible)
February 15, 2000

Thank the Internet for making cheap even cheaper. A new generation of online outfits is undercutting the traditional financial services industry. No, we're not talking about online banking heavyweights like and Net.B@nk. While those companies, like E*Trade's (Nasdaq: EGRP) recently acquired Telebank, take pride in offering market-stomping rates on interest-bearing checking and savings accounts, a new online breed has taken a slingshot to the mighty Vanguard.

Oh, the heresy of it all. It has been a staple of the Foolish philosophy to sing the praises of Vanguard's 500 Index Fund. Short of picking out individual stocks to buy and hold, it is easy to embrace the indexing concept. It is that mysterious, unmanaged benchmark that an astounding amount of actively managed mutual funds fail to edge out over the long haul.

Vanguard originated the index fund. Their version remains the largest. But, more importantly, it has respected the investor by charging rock-bottom expense ratios along the way. Last year, the fund costs charged came out to a scant 0.18% of assets. Some competing funds have often taken to waiving a portion of their fees to play in Vanguard's ballpark. The investment community has become too educated to accept high fees on what are essentially unmanaged portfolios.

You can't get much lower than eighteen paltry basis points. That's just $5.40 a year off Vanguard's $3,000 minimum initial investment during a hypothetically flat market. An upstart might absorb costs in the near term to draw in new accounts, down to nil even, but it could never commit to a policy so cost-prohibitive.

Until now. In November, began offering an S&P 500 Index fund that supposedly doesn't charge management fees. The catch? None. On the surface. But ideally, StockJungle would probably want you to eventually become an active member of its online community and receptive to the company's other financial products -- including three other mutual funds that do charge management fees (of 1.00% in all three cases).

The $5,000 minimum investment does not make the weighing station at the door any more attractive than Vanguard. There is also the legitimate concern that the fund is too small to mimic the index effectively. Since the fund is not big enough to own appropriately weighted stakes in the 500 companies that make up the index, StockJungle is merely buying S&P Depositary Receipts (AMEX: SPY).

I can't knock these receipts, which are more commonly known as Spiders. Our Rule Breaker Portfolio owned them through the first half of 1998 as a proxy for the market rather than hoard away cash until the next buy decisions would be made.

But it is not a true index fund that way. It's like a powdered milk milkshake or an Eggbeaters omelet. The fund is also small, presently holding just 4000 depositary receipts. I've seen more spiders in a dilapidated mansion. With just over a half million dollars in assets, inefficiencies are bound to occur as the company times its round lot purchases. As of yesterday the fund had lost 4.8% year to date. Meanwhile, Vanguard's fund -- like the dividend-adjusted S&P 500 itself -- is down 5.3%.

Good for StockJungle? Not really. If its fund can't lose as much as the S&P 500 during down periods, what hope is there that it can be managed to gain as much as the index when the market rebounds? Handling the inflow of cash has helped buffer the fall but may also sandbag the eventual rise.

Last year, Vanguard rose 21.04% -- exactly the same return as the S&P 500. Experienced management at the popular fund family has the indexing juggernaut cutting the gap closer than the already low expense ratios suggest. In a way, Vanguard's fund put on the finer reenactment of a fee-free fund in 1999.

That is because, in a cruel yet fitting twist, Spiders are not free to begin with. The American Stock Exchange takes a cut. What is the annual expense ratio on an S&P 500 Depositary Receipt? Why, 0.18%, of course.

The irony here with StockJungle is that the lure is not as enticing as the hook itself. One of the funds that StockJungle hopes to bait customers into is its clever Community Intelligence Fund. The microcap offering is up 25.1% since the start of the year. It buys and sells stocks that have been suggested by community members exclusively. Granted, it comes with more whirlwind turnover than a blender set on "churn." It is Foolworthy in theory but not in application. Still, it is a welcome surprise for a company whose fee-free gimmick will remain flawed until assets grow substantially.

But, again, a free fund. Wow. You just can't beat that. Can you?

You can. In December launched an S&P 500 Index fund that will not only absorb all management fees but will also rebate 0.01% back into the asset base annually.

This X offering trumps StockJungle and even Vanguard in many ways. No minimum investment. New accounts actually get a $20 bonus deposited automatically. And since the company has British giant Barclays (NYSE: BCS) managing the fund, it is a bona-fide offering that is buying into the actual companies that make up the index.

The downside here is that the fund has a $15,000 ceiling ($50,000 if one sets up the account for direct deposit). X, despite tapping former Intuit (Nasdaq: INTU) CEO Bill Harris as its own chief just two months ago, still has a lot of catching up to do with its larger banking rivals. Online bill-pay is still in the works. Its one-year CD rate of 6.25% falls shy of Net.B@ank's and Telebank's 6.5% and 6.76% certificates, respectively. A revolutionary process where accountholders would be able to liberally transfer funds among themselves had to be tweaked after a few unauthorized transactions were made.

So X is not perfect. No online financial service company is. However, when you begin to consider the many advantages of the growing Web-based institutions (and, yes, most are FDIC-insured just like your local bricks-and-mortar bank) the Internet holds a wad of promise in the realm of online banking. Today these companies may be absorbing costs in one area and hoping to subsidize it elsewhere, but if you pick and choose your needs you will probably come out ahead. There's no free lunch, but they're giving away some of the side dishes.