More choices lead to confusion. Choosing from thousands of index funds is a daunting task. Even comparing any two funds is difficult without knowing key metrics. This post will help you evaluate and choose an index fund based on its merits.
This post will teach you the analysis factors that matter most. So you don’t have to break your head during a search for an ideal fund.
Picking an index fund is not easy. You will see the reasons below. Hence before sitting down to analyze and choose index funds, you should be convinced that index funds are good Investments for you. Learning the benefits of these funds is the first and foremost step.
Why Picking an Index Fund is a Daunting Task?
There are two reasons why selecting funds is difficult for many investors.
- The existence of thousands of funds.
- Lack of expertise and conviction.
The existence of thousands of funds
A huge number of indexes exist in US and globe. Some indexes span multiple countries. They are based on sectors, size of companies and many other factors.
Wikipedia lists at least 80 popular indexes in the US. Name any index, you will most probably find at least one tracking fund. For example, let us randomly pick an index “S&P SmallCap 600” from the Wiki list. Let us now check for associated funds.
Let us do a google search using keywords “funds that track S&P SmallCap 600”. (An index fund can be a mutual fund or an ETF.) Results lead us to three ETFs from big players iShares, SSGA and Vanguard. Similarly,for any index, you will most probably find at least one tracking fund.
Lack of expertise and conviction.
The second reason why choosing fund is hard is a lack of expertise. Even who invest in individual stocks run short of time for in-depth analysis. Hence, analyzing funds that hold hundreds of assets (stocks, bonds, commodities, etc) will put your knowledge and time to test. Unless your analysis is sound, you will lack the conviction to a make a good choice in identifying funds.
What are Index Funds? How to Choose a Fund?
Index funds are designed to mimic the performance of an index. At times a fund can beat its parent indexes by a small margin. At some other times, a fund can trail by a margin.
“Index fund” can denote both mutual funds and ETFs (Exchange Traded Funds) that track benchmark indices like S&P 500.
Note: The popularity of ETFs is growing. By 2018 over 3 trillion dollars of assets have been invested in ETFs. While the mutual funds are still popular with assets around 20 trillion dollars, the growth of ETFs is unmatched.
Now you are going to see key factors to evaluate an index fund.
1 Previous Returns
Everyone invests for reasonable or good returns. Studying previous returns is the first step in choosing an index fund. What should be the timeframe you should analyze? You will now find the answer.
Common advice is to observe past 3 or 5 years data. However, if you are going to invest longer (say 10 or 20 years) you may choose a longer time frame. There are different schools of thought for deciding the duration. But a simple rule is this: Longer the duration better will be the prediction. The reason is, with long durations, the swings due to volatility will cancel out each other.
With all other factors remaining same, a higher returning fund is better than a lower returning one. But, this factor does not consider the risks like volatility, which we will see in a while.
Regarding returns, do not check a single fund in isolation. Instead, use this factor to compare funds. Here is an example to emphasize the above point. Assume there was an economic recession in last 2 years. During this time most funds would have given lower than expected returns. If you look at a single fund, the returns may be disappointing. In such case, a comparison between two or more funds will make sense.
Why is long timeframe for observation better?
For illustration purposes, assume two broad funds A and B. Let A track all large-cap stocks in the US while B tracks small and mid-cap.
Let the returns for A and B be the following.
|Funds||1-year return||3-year return||10-year return|
The above numbers are deliberately given to help you understand the importance of duration of observation.
From last one year returns, A looks better than B. The picture changes if you observe last 10 year returns. These kinds of conflicting numbers are a starting point for an in-depth analysis. For example, there could be a favorable sentiment towards the large-cap stocks in last year. If you analyze deeper, you can find the companies or sectors that produced high returns for fund A compared to B. If you can find 2 or 3 factors responsible for fund A returns, the next question you have to ask is this: Will those factors continue to give high returns in the coming years. For example, if you plan to invest for 3 years, you have to make an educated guess whether large caps are going to outperform small camps for the next 3 years. If you are convinced of your analysis, you can comfortably choose fund A over B.
The kind of analysis we saw above is going to take time. But the time invested in the beginning will help you avoid unpleasant returns in the future.
The above example was an illustration of how to evaluate returns. Don’t just check which fund offered higher returns but also analyze why the returns were high. “Why” is more important than “which”.
Comparing return percentages will not only help you decide between different types of funds like large and mid-cap funds but will also help you choose between two funds covering similarly sized companies. For example, you can compare funds that track large-cap tech companies with those tracking large-cap oil companies.
Where can you find the return percentages?
Just like individual stocks, every index fund has a ticker. The first step is to identify the ticker associated with a fund. You can google for the ticker. Or you can visit the fund provider website to find the symbol. For example, for “Vanguard Total Stock Market Index Fund” a simple google search will reveal the symbol, which is VTSMX.
If you visit Yahoo Finance and search VTSMX you will see the chart and financial data for VTSMX. Yahoo Finance usually displays Year-to-date returns below the chart. To find the returns for other time frames like 3 and 5 years, head over to the “Performance” tab and scroll down a little. You will find the data you are looking for.
2 Expense Ratio
The expense ratio is another metric to compare different funds. (Annual returns data already account for management expenses.) The expenses we are talking about are the costs incurred to operate and manage funds. Some prominent costs include the following.
- Fee for the fund managers
- Administrative expenses (office expenses, transportation costs, etc.)
- Marketing costs
High expense ratios negatively impact the returns. So companies try to keep this ratio as low as possible.
What is a turnover ratio? How it impacts expense ratio?
Usually, assets of a benchmark index don’t change often. Hence, the frequency of rebalancing portfolios is minimum for index funds, Frequency of change in assets is called the turnover ratio. For example, if 20 stocks from an index with 1000 stocks are replaced by new stocks, then turnover ratio is 20/1000 x 100% = 2%
Many will agree that an ETF tracking an index will have lower expense ratio than a mutual fund tracking the same index. Both funds are same in principle. But implementation of ETFs is slightly different and is a reason for the lower expense ratio.
In ETFs, the creation and redemption of shares are an “in-kind” process between an authorized participant and ETF provider. We are not going to see this process in detail now. Just understand this: In ETF, creation and redemption of shares are non-taxable events. In the case of index mutual funds, the fund managers have to pay any transactional costs arising from buying or selling shares.
To check the above point, let us compare the expense ratios of Vanguard Total Stock Market Index Fund against the corresponding ETF.
|Vanguard Total Stock Mkt Index Fund (VTSMX)||0.15%|
|Vanguard Total Stock Market ETF (VTI)||0.04%|
In the above comparison, the expense ratio of the ETF is just about one-third of the mutual fund.
ETFs are traded on open exchanges. Hence they may incur higher transactional costs over the mutual funds. You should keep an eye on that too.
3 Brokerage Commission and Annual Maintenance Fee
Individual investors buy and sell funds through brokers. In some cases, you can transact directly through the fund creators. For example, Vanguard allows you to transact if you open a trading account.
Usually, brokers or fund providers charge a commission for each transaction. These commissions are not included in expense ratios. So you should evaluate them separately before choosing your index fund.
Many investors overlook commission fees and end up hurting their overall returns. To demonstrate, let us see a simple example.
Assume two companies offer two funds A and B respectively. Let them be identical in all aspects except for the transaction costs.
Let fund A has a transaction fee of $4 for every $10,000. Let the fee become $2 for transactions over $10,000.
Let fund B has a transaction cost of $6 for every $50,000 invested. And for transactions over $50,000, let there be no commissions.
To choose between the funds A and B, you should think about your investment size and frequency. For example, if you are comfortable investing lesser than $10,000 every time, fund A may suit you.
In case your transactions will exceed $10,000 but will be lesser than $50,000, fund A will suit you again.
However, for investments over $50,000, fund B will be least expensive.
Apart from commissions, some companies charge an annual maintenance fee. You should never overlook the maintenance fee.
For example, consider the previous example. Let the company offering fund A charge annual fee of $20 while the second company charges none. Assume you are going to invest only once in a year. In this case, for any sum, fund B will be your obvious choice.
Consideration for ETFs
Usually, ETFs are traded more frequently than index mutual funds. The reason is mutual funds can be bought and sold only at the day closing. But index ETF funds are traded throughout the day in stock exchanges. Hence the number of transactions is usually greater than mutual funds. Hence, brokerages are more important while evaluating ETFs.
Different Transaction Costs for the Same Fund
The transaction fee for the same fund can be different when you buy through different brokers or companies. Hence “fee” factor should be used to compare two or more funds only for the same stockbroker. This factor can also be used to compare two brokers for the same fund.
Different transaction costs for different account types
Transactions fees vary with account types. Many providers have multiple account types with different privileges.
How to know the transaction costs for index funds
You will find transaction fee details on websites of stockbrokers or fund providers. For example, consider a popular index fund Vanguard European Stock Index Fund Investor Shares (VEURX)
Assume you have an account with Fidelity and are willing to buy VEURX shares. To know the transaction costs, just head over to fidelity.com and type in VEURX in the search box on the top right corner.
You will be directed to a dedicated page for VEURX with all details including Transaction Costs. The website displays these costs under “Additional Information” section at the bottom. Click the “+” symbol adjacent to the section heading. The first point will elaborate the transaction costs.
Note: The transaction fee can be confusing as they vary with several factors like account type, fund, and transaction amounts. A simple solution is to call your account support.
Every investment carries risks. Though index funds are generally less riskier than individual stocks or other forms of mutual funds, still there are risks. The risks in index funds stem from the underlying benchmark. But how exactly to choose a fund from several choices based on risk? Can risk be measured? You will know in a while.
Three key risk-related parameters which will help you to choose a fund are the following.
- Beta (β – Measure of volatility)
- Alpha (α – Return over benchmark)
- Sharpe Ratio (Measure of reward for the risk taken.)
Statisticians use a technique called “Regression” to measure the above parameters. The word “regression” should not be new to you if you are from a mathematical or statistical background. Luckily, you don’t have to compute them. Most financial websites displaying fund price movements will list these values. For you to understand the risk parameters, this post contains illustrations with simple calculations. You will see them in a while.
To understand the risk-reward parameters, you have to learn what is Standard Deviation (SD). The reason is, all the three parameters beta (β), Alpha and Sharpe ratio depend upon standard deviation.
Assume funds A and B that have given the following returns for the last 5 years.
|Year||Fund A Returns (%)||Fund B Returns (%)|
Using the above values, the average annual returns can be calculated for the funds.
- Fund A: (6 + 3 + 1 – 3 + 8) / 5 = 3%
- Fund B: (4 + 2 + 1.2 – 2 + 6) / 5 = 2.24%
In the context of index funds, the standard deviation is a measure of how individual returns differ from their respective means.
To calculate the standard deviation for fund A, you have to follow the below four steps.
- Subtract the average return of fund A i.e 3% from year-wise return values.
- Square the resulting values from step 1.
- Find the average of the sum of squares.
- The square root of the step 3 result is the SD or standard deviation.
|Year||Fund A Returns (%)||Mean||Returns – Mean||(Returns – Mean)2|
The standard deviation for fund A = 3.85.
Similarly, we can calculate the standard deviation for fund B.
|Year||Fund B Returns (%)||Mean||Returns – Mean||(Returns – Mean)2|
The standard deviation of fund A is 3.85 and that of fund B is 2.70.
Thus, SD of B < SD of A.
This implies the fund B is “tighter” than A. In other words B more closely follows its mean. Given all the other factors are equal, fund B will swing lesser (ups and downs) than A. Fund B is more stable than A.
To know the impact of SD on fund returns, have a look at the following graphs. The first graph is a plot of fund A returns against its mean. The second is for fund B.
Have a look at the above graphs. The graph for “fund B” looks “tight” about its mean. But “fund A” is more “spread” about its mean. Higher the SD, more volatile are the returns.
Now let us discuss the three (SD dependent) risk parameters one by one.
4 Beta (β) (Measure of Volatility)
beta (β) is a more useful metric than standard deviation to measure volatility of a fund. The drawback of beta (β) is a lack of comparison with the underlying benchmark index. Why should you check volatility in conjunction with a benchmark? You will now see an explanation.
Index funds are designed to track or follow a benchmark index. For example, an S&P 500 tracking fund, will swing along S&P 500. If the benchmark falls, the fund returns will drop and vice versa. A good measure of volatility (risk) is about how exactly a fund swings along with the benchmark.
The formula to calculate beta (β) is this: beta (β) = standard deviation of the fund returns / standard deviation of the benchmark index.
Let us come back to our previous example. We calculated the funds A and B to have standard deviations 3.85 and 2.7 respectively.
To understand beta (β) and how SD can mislead, you will see two scenarios. The second case will be an eye-opener.
Case (I): Funds A and B track same benchmark with SD 2.6
Now let us calculate the beta (β) values for A and B.
- beta (β) for fund A = SD of A / SD of Benchmark Index = 3.85/2.6 = 1.48
- beta (β) for fund B = SD of B/ SD of Benchmark Index = 2.7/2.6 = 1.03
beta (β) of B < beta (β) of A. This means, B follows the benchmark more closely compared to A.
Case (II): Funds A and B track different benchmarks with SDs 2.6 and 1.3 respectively
- beta (β) for fund A = SD of A / SD of Benchmark Index 1 = 3.85/2.6 = 1.48
- beta (β) for fund B = SD of B/ SD of Benchmark Index 2 = 2.7/1.3 = 2.03
In this example, the beta (β) of fund B > beta (β) of A. Thus fund A is better than fund B.
This is a different scenario compared to case I. Hence, do not get mislead by lower SD. beta (β) is a more appropriate measure of volatility.
How to read beta
Reading and interpreting beta (β) is easy. Let us discuss three possible values.
- beta (β) = 1:
- You already know the formula for beta (β), which is SD of the fund divided by SD of the benchmark index. Therefore, beta (β) = 1 implies both the SD’s are equal. The fund almost exactly follows the benchmark provided R-Squared is high. (R-squared is a measure of correletion. We will see about that later.)
- beta (β) > 1:
- A higher than one beta (β) occurs when SD of the fund is greater than that of the benchmark. This condition occurs if the fund swings larger than the benchmark. You will see two examples to learn what a beta (β) of 1.3 indicates. (Note: 1.3 is 30% higher than 1. )
- When the benchmark moves up, say 3 units (of price points) in the positive direction, the index fund will move 1.3 x 3 = 3.9 units (in returns).
- If the benchmark moves 2 units in the downward direction, the index fund will move 1.3 x 2 = 2.6 units downward.
When the benchmark performs well, the fund returns better than the benchmark. But if the benchmark drops, the fund will drop further.
- beta (β) < 1:
- A lesser than 1 beta (β) denotes the funds are less volatile than the benchmark. For example, assume a fund with a beta (β) value of 0.75. If the benchmark moves 3 units upward, the fund returns will move 0.75 x 3 = 2.25 upwards. If the benchmark moves 2 units downwards, the fund will move 0.75 x 2 = 1.5 units downward.
Limitation of beta (β)
When we discuss beta (β), we have to discuss another statistical parameter called R squared. R Squared is important because you can trust beta (β) only for higher values of R squared. Experts recommend a value of at least 75% for R Squared for beta (β) to make sense.
What is R Squared? This metric is a measure of how two curves are correlated. In our case, one curve is the fund’s return while the other refers to the index. Below two diagrams will help you understand tightly vs loosely correlated curves. (These curves are just for illustration and not based on real numbers.)
While evaluating index funds using the beta (β), it is ok if you overlook R Squared. The reason is, the principle of index funds is to follow a benchmark. Hence, the correlation and R Squared will be high. Usually, the values of R squared for index funds will be around or above 90%.
Where to find beta (β)
You can find the beta (β) value of a fund from “risks” section of financial quotes. For example, let us check the beta (β) value for VTSMX. Head over to Yahoo Finance and search for VTSMX.
(At the time of writing this post) The beta (β) values for 3, 5 and 10 years respectively are 1.01, 1.02 and 1.03 respectively.
5 Alpha (Return Compared to Benchmark)
You invest in index funds to match the returns of a benchmark index. Through index funds, no one is expecting the returns to beat the benchmark. But, the returns should not trail by a big margin as well. Alpha (α) is a measure of the return of a fund in relation to the parent index.
A common formula to measure alpha is given below. (You will see a slightly varying useful version of this formula later.)
Alpha = Rfund - beta (β) x Rindex
Rfund denotes the return from the fund. beta (β), as discussed earlier, is a measure of the volatility. Rindex is the return of the benchmark index.
The term beta (β) x Rindex is the expected return from the fund depending upon its risk. Higher the beta (β), higher is the expected return.
To understand alpha, let us see an illustration.
Assume a fund with a beta (β) value of 1.3. (beta (β) of 1.3 means, the fund is 30% more volatile than the benchmark.)
Let the average annual return for the benchmark index over past 3 years be 10%.
Let the returns from the fund be 12%.
Now, Alpha = 12 – 1.3 x 10 = 12 – 13 = -1%
A negative 1% denotes that the fund has trailed its expected returns by 1%.
You can use Alpha to compare the returns between two funds. In general, passively managed funds don’t have a significant Alpha. The reason is objective of most of the index funds is to mimic the benchmark. But some index funds, when smartly managed can produce higher returns than the benchmark. The other way round, a negative alpha is also possible (primarily due to inefficient managers or higher fees.).
Jensen’s alpha is a variant of the standard alpha. The objective is to isolate the impact of risky investments.
Jensen's Alpha = (Rfund - Rriskfree) - beta x (Rindex - Rriskfree)
In the above formula, Rriskfree denotes the return from a risk-free investment. If you are in the US, recent treasury bill rate is usually substituted in place of Rriskfree.
Note: Some index funds and ETFs are designed with an objective of higher alphas. The structure (composition) of the fund will reflect the objective. For example, an aggressive ETF may have the following composition.
- 80% of assets invested in the same proportion as the benchmark index.
- 20% invested in different assets expected to bring more returns overall.
Where You Can Find Alpha
You can find alpha of a fund from any financial website. For example, at the time of writing this post, alpha values for VTSMX displayed in Yahoo Finance are – .49, -0.57 and -0.1 for 3, 5 and 10-year time frames respectively.
6 Sharpe Ratio
Sharpe ratio is yet another risk-reward metric but with a difference. You have to know the limitations of alpha before learning the benefits of Sharpe ratio.
Limitations of alpha are the following.
- Alpha measurement depends upon beta (β). Whereas beta (β) is meaningful only if R squared is sufficiently high. (Note: This limitation is rarely felt in index funds because R squared values for index funds are usually high.)
- Alpha makes sense only if two funds following the same benchmark are compared. But when choosing an index fund, often you will analyze funds tracking different benchmark indexes. For example, you may need to compare a fund tracking S&P 500 to another fund tracking all emerging market large-cap stocks.
You can overcome the above limitations if you use Sharpe ratio. The formula for Sharpe ratio is given below.
Sharpe ratio = Rfund - Rriskfree / SD of the fund
Rfund refers to the return from the fund. Rriskfree denotes return from a risk-free investment (like treasury bond).
If you observe the above formula, you will find no beta (β). Thus, Sharpe ratio is independent of beta (β) and R squared. Also, there is no reference to benchmark returns. Hence, this metric should work well across funds tracking different indexes.
Now, let us see an explanation of the terms on the right-hand side. The denominator SD is a measure of the volatility of a fund. The numerator is the return of the fund over risk-free returns. High SD means high risk. When SD is high, denominator value is high and hence the returns should be high enough to maintain a good Sharpe ratio. When comparing or choosing index funds, higher the Sharpe ratio the better.
Let us see an illustration on how Sharpe ratio helps us to compare two funds.
Assume two funds A and B with SDs, 1.2 and 2.4 respectively.
Let the return of fund A be 2.6% and risk-free return be 0.2%.
The Sharpe ratio of fund A =
2.6 - 0.2 / 1.2 = 2
Let the return of fund B be 2.6% (same as that of fund B).
Then Sharpe ratio of fund B =
2.6 - 0.2 / 2.4 = 1
Sharpe ratio of A > Sharpe ratio of B.
Therefore, fund A gives better returns for the risk taken.
Now, for fund B to match the risk-reward ratio of fund A, the return has to be more than 2.6%.
Let the return of fund B be X.
Now let us find a minimum value for X so that the Sharpe ratio of fund B matches fund A (i.e 2).
2 = X - 0.2/2.4
X = 4.8 + 0.2 = 5%
Therefore, for fund B to match the risk-reward ratio of fund A, the return should be 5%.
Where to find Sharpe Ratio
You don’t have to calculate Sharpe ratio while comparing and selecting funds. These ratios are readily available in financial websites.
For example, according to CNN Money, the Sharpe ratio of VTSMX calculated over past 5 years is 1.50
7 Prediction of Future Returns Using Regression
Regression analysis is a statistical technique used to predict future values based on past data. Once you are able to predict returns of two or more funds, you will be able to choose one. The best thing about this analysis is anyone can do it using online tools or excel. You will see how in a while.
This technique can be applied to index funds and ETFs to predict future returns. Though a hundred percent accuracy is not guaranteed, this is a useful method to compare two funds.
For illustration, consider two funds A and B that track an imaginary X&Y 500 index. Assume that a popular analyst has given a forecast for X&Y 500 for the following year. Using the forecasted return, you can estimate the return from funds using regression analysis. You will now see the methodology.
For illustration purpose, let us assume imaginary values for the returns of X&Y 500 and the first tracking fund A. Let our timeframe of observation be 6 years.
|Years||X&y 500 Returns||Fund A Returns|
Regression analysis of the above data will give you an equation, In that equation, if you substitute a value for X&Y 500 return, you will be able to predict fund A’s returns. For example, if a popular analyst like Moody’s has forecasted 15% return for X&Y 500 in the following year, you can estimate the return of fund A fund for next year.
You can use online calculators or excel formulas to find regression equation based on past data.
For illustration, we shall use the online regression calculator at Graphpad.
As the first step , enter return values in the columns. For simplicity sake, we have used the label X for X&Y returns and Y for fund A returns.
After you hit “Calculate Now” button, you will see a graph. The graph will have a straight line and points. In this graph, the X-axis represents X&Y 500 returns, while the Y-axis denotes fund A returns. This line is called the “regression line” or “line of best fit” for the values we entered.
More importantly, you will find a simple equation. Using this equation, you can predict future returns of your fund. If forecast for X&Y 500 is 5% the next year, the return from your fund will be.
For our example, the equation we got is
Y = 0.8890*X + 0.1513
For X&Y 500 return gain of 15%, the return can be calculated by substituting X = 15.
Y = 0.8890 x 15 + 0.1513
Y = 13.4%
Hence, we can expect 13.4% return from fund A if X&Y 500 gains 15% next year.
No regression analysis is hundred percent accurate. The accuracy can be determined using a parameter called R-squared. Higher the R-squared higher the accuracy (Values range from 0% to 100%).
The online regression calculator that we just discussed will display R-squared value as well. You can see that value in the “Goodness of fit” section below the graph. For our example, the value is 0.9939. Expressed as a percentage, the value is 99.39%. Thus our fund A follows X&Y 500 closely. The measure of closeness is 99.39%.
Regression analysis tip
The power of regression analysis comes from applying real values instead of imaginary values we saw in our example.
For example, let’s say you want to predict returns of a fund that tracks S&P 500, you have to use historic return values for S&P 500 and the fund of interest.
The historical prices of S&P 500 (or other indexes) can be found from Yahoo Finance. Go to Yahoo Finance, type in S&P 500 and head over to historical prices section.
Note down December-end values of past, say 10 years. And get the previous 10-year returns of your fund from your fund provider or broker. Using those real values, you can find a regression equation using the method outlined above.
8 Devise Strategy and Choose Index Funds Accordingly
A good strategy is the starting point of picking an index fund. There are lot many indexes in US and global markets. There are specific indexes for small, mid and large caps, individual commodities, sectors, etc. Some indexes are broad while others are narrow. Some broad indexes track the whole US market while others track very few companies in a single sector.
You know that a lot of portfolio strategies exist for individual asset class investments like stocks. Do you have to follow a strategy for broader investments like index funds? The answer is yes. However, a portfolio strategy can be as simple as investing half the money in US stock market index fund and rest in emerging market funds. But devising a strategy is not a guesswork. Some factors to consider before planning your portfolio are the following.
- Knowledge and Expertise:
- A common advice is not to invest in something you don’t understand.
- Objective and Time Frame:
- For example, broader funds are safer than narrow funds. Hence, if you consider investing for retirement, your inclination should be towards safer funds.
- Forecasts by Analysts on an Index:
- Let’s say popular analysts have forecasted high returns in emerging market index funds. In that case, you may choose to invest a portion in them.
Don’t worry if you are not confident of devising a strategy. In that case, you can start with basic strategies like dividing your investment between a broad stock index fund and a broad bond index fund. Later based on performance, you can rebalance your existing investments or find new opportunities.
Should you choose a narrow fund?
An objective of index funds is to reduce risks compared to individual equities/stocks. But there will be some people willing to trade off risks for returns. For example, a person may believe that in next 5 years, a handful of tech companies are going to produce good returns. In such a case, he may choose an index fund tracking a tech sector benchmark. If the person’s analysis is correct, he may get higher returns from tech funds over broader funds.
You have to choose a broad or narrow fund depending upon your analysis and your risk tolerance. If you are confident of your analysis and are a risk tolerant person a narrow fund may suit you. If you are averse to risks and don’t have the time for analysis, a broader fund would be better.
9 Tax Efficiency
The amount of taxes you are going to pay will affect your net worth. The taxes are not accounted for in the expense ratio. Hence you should analyze the potential taxes upfront before choosing an index fund.
In case of index mutual funds, capital gains due to rebalancing will be distributed to investors. If from a benchmark, a company A gets replaced by B, then a fund manager will sell stocks of A and buy stocks of B. Now, any capital gain from the transactions will be a taxable income.
In general, most index funds are tax efficient. The reason is a lower turnover ratio. A turnover ratio is the percentage of assets that get replaced in a fund. For example, if from a fund of 1000 small caps, 100 get replaced with new company stocks, then the turnover ratio is (100/1000) x 100% = 10%
Since broad benchmarks will not change often, the taxes are will be on the lower end of the spectrum.
Are index ETFs more tax-efficient than index mutual funds?
An argument for all forms of ETFs (not just index tracking funds) is that they are tax efficient than traditional mutual funds. However, when you compare an ETF and a mutual fund tracking the same index, you will not find significant differences. Hence, tax comparison is more helpful for funds (regardless of ETF or mutual funds) tracking different benchmarks.
Note: Funds invested from 401 or IRA accounts have special tax benefits. Hence, you may not bother much about tax efficiently if you are investing from these accounts.
Hope the above post willl help you choose best index funds.
For those new to index funds, a big concern is where to start. There are hundreds of strategies floated by advisors. There is an endless number of ideas on how to divide investments between different index funds. The existence of thousands of strategies causes confusion. If you do not know where to begin, here is a “common-sense” advice:
Choose any fund you understand and is less risky. You can switch funds or rebalance as you gain experience and knowledge. Broad funds like Vanguard total stock market tracking funds are safe to begin. As you progress and watch your returns, you can execute new strategies based on your experiences and learnings. There is an infinite number of ways to reach your objective.
Don’t think which path is right. Just think if the path you have chosen is a sensible way to reach your objective.