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 0.10% 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 (VFINX), which charges only 0.18% and carries a minimum initial investment of just $3,000.

Unfortunately, not all index funds are that cheap. Let's compare a couple of S&P 500 trackers to see if you get anything by paying more:

Both funds have the same top holdings and, consequently, will perform about the same. However, Dreyfus' expense ratio is a hefty 0.50%, and you could wind up earning thousands less over the long term. In fact, over the course of decades, you could be poorer by more than $300,000 because of the higher expense ratio!

An example of reasonable expense ratios for other index funds would be 0.22% for the Vanguard Mid Cap Index (VIMSX), and 0.23% for the Vanguard Small Cap Index (NAESX).

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 as we've just seen, while the differences may seem small, they are huge 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 0.10% 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 22% to 10%. 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. Microsoft and Pfizer are Inside Value recommendations. Bank of America is an Income Investor recommendation. This information is brought to you by the Fool'sdisclosure policy.