For those who don't want to spend a lot of time looking at individual stocks, index mutual funds are one of the most useful tools that investors saving for retirement have at their disposal. But in order to avoid nasty surprises, it's worth the effort to look closely at exactly how your index fund invests your money.
Tracking error
You'd think that index funds with the same basic investment objective would perform pretty much in line with each other. After all, similar funds tend to own the same stocks, and so their overall returns aren't likely to be all that different from each other.
Yet that assumption has turned out to be wrong recently, as an article in The Wall Street Journal from earlier this week discussed. As it turns out, there are some pretty strong differences among funds, and there are two main reasons why: Not all index funds track the same index, and funds use a variety of methods to try to replicate their benchmark index's return.
Same asset class, different index
With index mutual funds and exchange-traded funds having become increasingly popular, there are a lot more indexes that various investment vehicles try to track.
Fortunately, the transparency of ETFs and their indexes makes it relatively easy to see differences among fund holdings. For instance, investors in large-cap U.S. stocks can track the popular S&P 500, or they can opt for less widely followed indexes, such as the Russell 1000. Both have big names like ExxonMobil (NYSE:XOM) and Microsoft (NASDAQ:MSFT) at the top of their holdings lists. But the Russell index also includes companies that the S&P leaves out, such as Markel (NYSE:MKL), Arch Coal (NYSE:ACI), and Garmin (NASDAQ:GRMN).
As a result, if you own an investment that calls itself a large-cap fund, you shouldn't assume that it tracks the S&P 500. In 2009, the S&P gained about 26.5%. But the Russell was up 28.4% -- not a huge difference, but still significant enough to notice.
Same index, different stocks
Of course, if your fund tracks a different index than another fund, then getting different returns shouldn't be all that surprising. But in some cases, even funds that track the exact same index come up with different results.
For instance, the Journal article gives an example of two emerging-markets ETFs, one from iShares and the other from Vanguard. Both track the same MSCI index of emerging-markets stocks. Both count Samsung and Petroleo Brasileiro (NYSE:PBR) among their top 10 holdings. Yet when you look at how much each has invested in particular stocks, you see marked differences. The iShares ETF holds almost 3% of its assets in Taiwan Semiconductor (NYSE:TSM), for example, while the same stock represents less than 1% of the Vanguard ETF's assets. That, in part, led to a difference of four percentage points between their respective returns last year -- and both trailed the actual index.
If each fund tracks the same index, then why would their holdings be different? The answer is in the methods various index funds use to try to replicate their index's performance. Some funds simply buy all the stocks in the index. That's obviously the most accurate way to track, but it also increases transaction costs, especially with large indexes that contain fairly illiquid stocks.
To try to cut those transaction costs, other funds use statistical sampling techniques to try to cherry-pick a subset of stocks from the index. By doing so, they hope to mimic or even outperform the index without buying all of its component stocks. How well it works, though, varies from fund to fund and from year to year.
Know what you own
As an investor, the key takeaway from this is that if you own an index fund or ETF, you can't just ignore it. Keep tabs on exactly what benchmark your fund is tracking, and compare its results to the benchmark's returns consistently to make sure that you're not seeing an inordinate amount of tracking error. Paying close attention is the only way to ensure that your index fund isn't steering you wrong.
Whether you buy index funds or stocks, now's a great time to invest. Let Fool Brian Richards show you how to make more money without blowing a great opportunity.
