TRADE

INVESTING GUIDE TO MUTUAL FUNDS

The Hidden Differences Among Index Funds

By SHAUNA CROOME Updated May 12, 2024
Reviewed by GORDON SCOTT

Part of the Series

Guide to Index Fund Investing

We Care About Your Privacy

We and our 100 partners store and/or access information on a device, such as unique IDs in cookies to process personal data. You may accept or manage your
choices/ Getty
d3sign by clicking
Imagesbelow, including your right to object where legitimate interest is used, or at any time in the privacy policy page. These choices will be
signaled to our partners and will not affect browsing data.
We and our partners process data to provide:
Index funds,
Store and/or
which
access
trackonana device.
information
underlying market
Use limited data to index
have grown
select advertising. Create in
popularity
profiles
withadvertising.
for personalised
investorsUseover theto years.
profiles select A fund
might trackadvertising.
personalised the S&PCreate
500profiles
or Dow Jones Industrial
to personalise Average,
content. Use profiles allowing
to select investors
personalised to ownadvertising
content. Measure each ofperformance.
the holdings within
Measure content
performance.
those Understand
indices. audiences through statistics or combinations of data from different sources. Develop and improve services. Use limited data to select
content.
List of Partners (vendors)
Although index funds do attempt to replicate highly similar performance compared to their respective indices, no
fund's performance is guaranteed to be the same as similar funds; nor will a fund necessarily replicate the index it
Accept All
tracks. Although the differences between index funds can be subtle, they can have a major impact on an investor's
return over the long term. Reject All

Show Purposes
KEY TAKEAWAYS
 Index funds, which track an underlying market index have grown in popularity with investors over the
years.
Fees and expenses ratios or operating expenses can vary between index funds and erode an investor's
return.
An index fund might not track the underlying index or sector exactly causing tracking errors or variances
between the fund and the index.
Some index funds might only hold a few components, and the lack of diversification can expose investors
to the risk of losses.

Understanding the Hidden Differences Between Index Funds

An index fund is a type of exchange-traded fund (ETF) that contains a basket of stocks or securities that track the
components of an existing financial market index. For example, there are index funds that track the Standard &
Poor's 500 Index. Although investors can't buy an index per se, they can invest in index funds that are designed to
mirror the index. In other words, an index fund tracking the S&P would have all 500 stocks from the S&P 500 in the
fund. Index funds tend to provide investors with broad market exposure or exposure to an overall sector.

As a result, index funds are passive investments, meaning that a portfolio manager is not actively stock-picking by
buying and selling securities for the fund. Instead, a fund manager selects a combination of assets for a portfolio
intended to mimic an index. Because the fund's underlying assets are held and not actively traded, operating
expenses are usually lower than actively managed funds.

At the onset, it might be reasonable that the index fund should track the index with little difference, and other
funds tracking the same index should all have the same performance. However, a deeper look uncovers numerous
disparities across fund types and helps to uncover some winners.

Expense Ratios
Perhaps the most distinctive hidden difference between index funds is a fund's operating expenses. These are
expressed as a ratio, which represents the percentage of expenses compared to the amount of annual average
assets under management.

Investors who invest in index funds should, theoretically, expect lower operating expenses since the fund
manager doesn't have to select or manage any securities. However, operating expenses can vary between funds.
Expenses are very important to consider when investing since expenses can erode an investor's return.

Consider the following comparison of 10 S&P 500 funds and their expense ratios as of April 2003:
Image by Sabrina Jiang © Investopedia 2020

The different bars in this chart represent different funds. Bear in mind that the yearly return of the S&P 500 as of
the end of April 2003 was approximately 5%, taking into specific account that expense ratios range from 0.15% to
almost 1.60%. If we assume that the fund tracks the index closely, a 1.60% expense ratio will reduce an investor's
return by about 30%.

Fees
Index funds with nearly identical portfolio mixes and investing strategies can have different fee structures. Some
index funds charge front-end loads, which are commissions or sales charges applied upfront when the initial
purchase of an investment occurs. Other funds charge back-end loads, which are charges and commissions that
occur when the investment is sold. Other fees include 12b-1 fees, which are annual distribution or marketing fees
for the fund. However, the 12b-1 fee can be charged separately or be embedded within the fund's expense ratio.

The fees, along with the expense ratio, should be considered before buying an index fund. Some funds may
appear to be a better buy since they might charge a low expense ratio, but they might charge a back-end load or a
12b-1 fee separately. The fees and expense ratio, when taken cumulatively, can dramatically impact an investor's
return over time.

Typically, larger, more established funds tend to charge lower fees. For example, the Vanguard 500 Index Admiral
Shares fund (VFIAX), which tracks the stocks of 500 of the largest U.S. companies, charges a 0.04% expense ratio as
of April 26, 2024.

The lower fees could be the result of management experience in tracking indexes, a larger asset base, which could
enhance the ability to use economies of scale in purchasing the securities. Economies of scale are cost savings
and advantages reaped by large companies when they can buy in bulk, thus lowering the per-unit cost.

Tracking Errors
Another method for effectively assessing index funds involves comparing their tracking errors and quantifying
each fund's deviation from the index it mimics.

Tracking error measures how much divergence occurs between the fund's value and that of the index the fund it's
tracking. The tracking error is usually expressed as a standard deviation, which shows how much variance or
dispersion exists between the fund's price and the average or mean price for the underlying index. Sizable
deviations indicate large inconsistencies between the return of an index fund and the benchmark.

This large divergence could be an indication of poor fund construction, high fees, or operating expenses. High
costs can cause the return on an index fund to be significantly lower than the index's return, resulting in a large
tracking error. As a result, any deviation can create smaller gains and larger losses for the fund.

The figure below compares the S&P 500's return (red), the Vanguard 500 Index Admiral Shares (green), the Dreyfus
S&P 500 (blue), and the Advantus Index 500 B (purple). Notice the index fund's divergence from the benchmark
increase as expenses increase.
Image by Sabrina Jiang © Investopedia 2020

A Fund's Holdings
Just because a fund says index fund in its name, doesn't necessarily mean it tracks the underlying index or sector
exactly. When screening for an index fund, it's important to remember that not all index funds labeled "S&P 500"
or "Wilshire 5000" only follow those indexes. Some funds can have divergent management behavior. In other
words, a portfolio manager may add stocks to the fund that are similar to what's in the index.

Take for example the Devcap Shared Return fund, which is a socially responsible S&P 500 index fund. As of Jun. 4,
2003, it had an expense ratio of 1.75% and charged a 12b-1 fee of 0.25%. Another fund, the ASAF Bernstein
Managed Index 500 B, was categorized as an S&P 500 index fund, but it actually sought to outperform the S&P 500.
Image by Sabrina Jiang © Investopedia 2020

Sector index funds that track a sector in the economy are often open to subjectivity by the investment manager as
to what's included in the fund. For example, the SPDR S&P Homebuilders exchange-traded fund (XHB) is known
for tracking stocks in the homebuilding industry. An investor buying the fund might assume it contains only
homebuilders. However, some holdings are stocks of companies related to the industry. For example, Whirlpool
Corporation (WHR), the appliance manufacturer, the home supply store, Home Depot (HD), as well as Aaron's Inc.,
which is a rent-to-own furniture retailer, are all included.

Also, if a portfolio manager for an index fund performs additional management services, the fund is no longer
passive. In other words, a fund might have the goal to outperform the index, such as the S&P 500, leading to
holdings that include companies and securities outside the index being tracked. As a result, funds with these
added selling features typically have fees well above average.

It's important for investors to analyze the holdings of an index fund before investing to determine whether it's a
true index fund or a fund that has an index-like name.

Lack of Diversification
Within the index fund category, not all funds listed are as diversified as those tracking an index such as the S&P
500. Many index funds have the same properties as focused, value, or sector funds. In general, investors will notice
that focused funds tend to hold fewer than 30 stocks or assets, and they may often hold them within the same
sector—though there is no specific limitation on the number they can hold. In theory, the lack of diversification in
sector funds can expose investors to higher risk than a fund tracking the S&P 500, which is comprised of 500
companies within various sectors of the economy.

Special Considerations
Careful investigation of index funds before buying includes making sure that there are little-to-no tracking errors
and that fees and expenses ratios are low. Also, it's important to understand the investment manager's goal for
the index fund and what holdings or investments are included in order to reach that goal. If the goal is considered
aggressive, the fund's investments might deviate from the underlying index.

The need to consider fees becomes even more important relative to increased risk factors—fees reduce the
amount of return received for the risks taken. Consider the following comparison of Dow 30 index funds:
Image by Sabrina Jiang © Investopedia 2020

An investor's risk tolerance and time horizon can impact the choice of investments. A retiree would likely seek
index funds that are conservative or low risk since the goal might be to maintain the portfolio and provide income.
A Millennial, on the other hand, might choose a fund that has a more aggressive investment strategy designed to
offer growth since the Millennial has more time to make up for any market downturns. Risk tolerance and time
horizon are both important considerations when it comes to choosing an index fund.

ARTICLE SOURCES

Part of the Series

 Guide to Index Fund Investing

Introduction to Index Funds

Index Fund Examples

Index Fund Risks and Considerations

1 Index Mutual Funds vs. Index ETFs
2 5 Things You Need to Know About Index Funds
3 5 Reasons to Avoid Index Funds
4 Can an Index Fund Investor Lose Everything?
5 What Is Considered a Good Expense Ratio?
6 The Hidden Differences Between Index Funds
CURRENT ARTICLE

Related Articles

INDEX TRADING STRATEGY

5 Reasons to Avoid Index Funds

GUIDE TO MUTUAL FUNDS

Mutual Funds vs. Money Market Funds: What's the Difference?

ETFS
How To Invest in the S&P 500

INDEX TRADING STRATEGY

Where Can I Find Historical Stock/Index Quotes?

INDEX TRADING STRATEGY

Russell 3000 Index: Stocks and Limitations
INDEX TRADING STRATEGY
Closed-End Funds vs. Open-End Funds: What's the Difference?

Partner Links

Related Terms
Russell 3000 Index: Stocks and Limitations
The Russell 3000 Index measures the performance of the largest 3,000 U.S. companies more
Unit Investment Trust (UIT): Definition and How to Invest
Unit investment trusts (UIT) buy a fixed portfolio of securities and allows investors to redeem their “units,” similar to a mutual
fund. more
Tracking Error: Definition, Factors That Affect It, and Example
Tracking error tells the difference between the performance of a stock or mutual fund and its benchmark. more
What Is the Profitability Index (PI)?
The profitability index (PI) measures a proposed project's costs and benefits by dividing the projected capital inflow by the
investment. more
What Are Index Funds, and How Do They Work?
Index funds are pooled investments that passively aim to replicate the returns of market indexes. more
What Is the Russell 1000 Index? Definition, Holdings, and Returns
The Russell 1000 Index, a subset of the Russell 3000 Index, represents the 1,000 top companies by market capitalization in the
United States. more
About Us
Terms of Service
Dictionary
Editorial Policy
Advertise
News
Privacy Policy
Contact Us
Careers
EU Privacy

Investopedia is part of the Dotdash Meredith publishing family.