Don't Give Up on Index Funds Yet

Andrew Clark, a senior research analyst at investment-research firm Lipper, thinks so. He says it won't be long before the index fund loses its place as the king of the passively managed funds to its nimbler, and cheaper rival, the exchange-traded fund, or ETF.

"My personal opinion is that [index funds are] living on borrowed time," he says.

Like index funds, ETFs are structured to mimic the performance of a benchmark index. Unlike index funds, their value updates throughout the course of the trading day, and they can be bought and sold like stocks. And ETFs are cheap. The average expense ratio for ETFs is 0.42% vs. 0.93% for index funds, according to Lipper. (For an in-depth look at how ETFs work, see our Essential Guide to ETFs.)

For all of these reasons, ETFs are gaining in popularity. The American Stock Exchange, the hub of ETF activity, now lists 164 ETFs (though about half of those listings are about to jump ship for the NYSE). At the end of June, total ETF assets were $244.7 billion, vs. $102.0 billion at the end of 2002 and $65.5 billion at the end of 2000, according to Lipper.

By now you're probably wondering why we're running an index fund screen this week. It's kind of like recommending a VCR in this DVD-era, right? Not exactly. We're not ready to eulogize index funds just yet.

For one thing, a number of fund companies have responded to the onslaught of ETFs with lower fees on their index funds. This is particularly true among S&P 500 index funds, which have engaged in a fee war over the last year. The current leader is the E*Trade S&P 500 Index (ETSPX), which boasts an expense ratio of just 0.09%. Fidelity Spartan 500 (FSMKX), which didn't make it through our screen because of its $10,000 minimum initial investment, is next at 0.10%. And then there's the classic Vanguard 500 (VFINX), at 0.18%. (Vanguard offers an "Admiral" share class, with a fee of 0.09%, for investors with $100,000 in the fund, or $50,000 and 10 years of service as a shareholder.)

Clark thinks that index funds with fees of less than 20 basis points (or two-tenths of a percentage point) are "in the game." Of course, apples to apples comparisons of index fund fees with ETF fees aren't exactly fair to begin with. That's because, for now, ETFs can be purchased only through a broker, a transaction that in itself involves a fee. Most index funds, on the other hand, are available without a transaction fee when purchased directly through the issuing fund company.

That fee doesn't matter much if you're the kind of investor who's going to hold on to a fund for many years. But if you're anticipating doing some portfolio rebalancing, or if you prefer to dollar-cost-average into your funds, then the tab can add up. In fact, this would most likely make a cheap index fund the clearly superior choice.

It's also worth knowing whether your index fund is a by-the-book indexer or not. Lipper has three baskets for index funds: pure index, enhanced index, and index-based. The latter two categories have some leeway in the way they go about tracking their benchmarks. Of the funds on our list this week, only two, SSgA Disciplined Equity (SSMTX) and Payden Market Return (PYMRX), are considered enhanced. The rest are pure in Lipper's eyes.

Beyond consulting with Lipper, you could check a fund's R-squared to see how closely the portfolio hews to its benchmark index. R-squared measures how much of a fund's performance is attributable to changes in its benchmark index; the closer the number is to 1, the tighter the correlation.

Finally, go ahead and take a look at the returns. The range in performance among funds that are tied to the same benchmark will be rather small, but a sense of past performance will show you how even slightly higher fees can eat into returns. Remember, when it comes to index funds, cheapness is a major virtue.

The Criteria
This week, we scanned Lipper's database of international, small-cap, midcap, large-cap, and S&P 500 index funds for the top performers with the lowest fees. We required returns over the last three and five years to be in the top half of the fund's classification, and expense ratios to be in the bottom 50%. Each of the 16 funds on our list is a no-load fund and requires a minimum initial investment of no more than $5,000. They are open to new investors, and carry net total assets of at least $50 million.