Which Index Fund?

If you're ever looking for some Foolish musings but can't get to (perhaps your dog ate the F on your keyboard), visit the Dallas Morning News website (registration required) and read what Scott Burns has to say.

Here's a guy full of all kinds of good insights (not to mention his Couch Potato Portfolio). In a recent article, "Index funds not created equal," Burns quotes some interesting stats:

  • Twenty years ago, there were just two index funds: the Vanguard 500 Index fund and the Vanguard Small Cap Index fund. Today, there are 678 index funds, 544 of which invest in domestic stocks.

  • The average expense ratio (i.e., how much the fund charges each year to cover administrative costs) for the domestic index funds is 0.76. Many index funds sport expense ratios that far exceed those charged by their actively managed peers.

  • Portfolio turnover in domestic index funds averages 95%. In other words, only 5% of the investments in a fund are still there a year later.

The theory behind index investing is that it's a simple way to benefit from the growth of the overall stock market. It's no-brainer, couch-potato investing. But it's not so simple when there are hundreds of funds to choose from. So what's an investor to do? Let's hearken back to why index investing works.

Two of the biggest reasons to invest in an index fund are low costs and low taxes. Many index funds charge 0.20% a year to operate and keep turnover to a minimum (which reduces taxes to fund shareholders). There's no reason to choose an index fund that charges 0.76%. That's like buying an umbrella with holes.

How big of a deal is paying an extra 56 basis points a year? Over the long term, it can make a noticeable difference. Over 20 years, a $10,000 investment growing at 10% would be worth $73,281. However, that investment earning 56 basis points less each year would be worth just $65,575.

Then there's the question of which kind of index fund to choose -- an S&P 500 fund? A Russell 2000 fund? The Nasdaq 100?

If you're truly going for autopilot investing, look for a total market fund, such as one based on the Wilshire 5,000 (which, despite its name, has more than 6,500 companies in its index). Though it has 6,000 fewer companies, the Standard and Poor's 500 is also a good barometer of the overall market.

For more on index investing, visit our 60-Second Guide.

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