Why Low Expense Ratios Aren't Only Difference Between Index Funds
Henry Clay Webster

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If you've ever weighed the pros and cons of investing in index funds, you're no doubt familiar with the pro-index argument that the lower cost of passively managed funds helps them beat more expensive actively managed funds in the long run. Countless studies, including the latest one from industry-heavyweight Morningstar, conclude that funds that charge less have a higher tendency of outperforming their more expensive peers.

This argument has received renewed support among investors since the start of the most recent market downturn. Actively-managed stock funds have continued to suffer large net outflows while index funds overall have continued to see inflows. Much of that cash flowed to products like exchange-traded funds, and this new popularity has helped index fund investors by initiating a price war among already extremely low-cost funds. In early October, Vanguard lowered the initial investment requirement for its admiral share class from $100,000 to just $10,000 on 52 of its funds. This reduced the Vanguard 500 Index fund's already low 0.18 percent annual expense ratio to just 0.07 percent, surpassing Fidelity's S&P 500 tracker -- the Spartan 500 Index fund -- by three basis points (or three hundredths of a percent).

So if low cost is the greatest predictor of higher returns, should you cash in on this price war? "If you try to say this is just a one-dimensional decision based solely on expense ratios, you're missing some of the nuances of intelligent fund design and intelligent risk exposure that I believe will lead you to better returns," says Ben Brinkerhoss, chief investment officer of Irvine, Ca.-based Index Fund Advisors. Here are several reasons why narrow cost differences shouldn't be your only consideration in selecting an index fund:

1. A few basis points won't save you all that much.

When you're investing in an index fund that tries to track an index -- say the S&P 500 or the Russell 2000 Small-Cap Index -- its return is going to be incredibly close to other funds tracking the same index. Based on the Securities and Exchange Commission's mutual fund calculator, you can see the difference between a fund that costs 10 basis points and one that costs 20 basis points. If you invest $10,000 in each fund over a 10-year period, both providing an annualized 8 percent return, the costlier fund will only charge you $213 more in all that time. That may be enough to make you want to switch to the lower cost fund, but the savings only amount to a half tank of gas per year. "Only if you start getting to 15, 20, 30 basis points, does it start getting significant over a 5 or 10 year period," says Norm Mindel, founder of Forum Financial Management in Lombard, Ill.

2. Taxes, taxes, taxes.

"You don't want to sell out of a fund, if you're going to take a huge hit on your capital gains taxes just to get into a lower-cost fund," says Brinkerhoss. If you sell out of one index fund in order to buy another, you could face a decent size capital gains tax. Even if you're in the lowest tax bracket, you'll pay 5 percent of your capital gains to Uncle Sam. Since 5 percent is 50 times more than a 10 basis point difference, this is probably not a good bet on your part. A 5 percent tax now wouldn't be offset by the slightly lower expense ratio unless you plan on investing your money in the cheaper fund for a considerable amount of time.

3. Securities lending often trumps a small difference in expense ratios.

One little-known feature of many funds is that they often lend their securities to short sellers for small fees. This action, called securities lending, sometimes provides some index funds with slight gains that can offset their modestly higher expense ratios. For example: "Based off of data between Oct. 2009 and Nov. 2008, the DFA U.S. Targeted-Value fund generated 25 basis points of revenue from securities lending. The Vanguard Small-Cap Value Index fund earned 9.2 basis points of securities lending. So right away the difference is 16 basis points," says Brinkerhoss. "[That's] going to swamp a small difference in expense ratios.

4. Index turnover costs.

Most index funds, because they track an index, buy and sell securities on the day the index includes or excludes a company. The problem is that the index's turnover is often announced weeks in advance. Knowing that huge quantities of stock will be bought on a particular day drives both individual investors and large hedge funds and institutions to buy the stock beforehand, which drives the price of the stock up before the date when the change actually happens.

In one case earlier this year, Samuel Lee of Morningstar wrote, "Standard & Poor's announced that Berkshire Hathaway would be joining the S&P 500. A curious thing happened: Berkshire's stock rocketed to around $76 from $68 in a few short days, a nearly 12 [percent] rise ... When the day rolled around, the index funds obeyed their mandates and bought more than $20 billion worth of Berkshire Hathaway stock at a 12 percent premium. It was a $2 billion payday on the index investor's dime."

"For the S&P 500 it is probably a drag, but when you look at a Russell 2000 reconstitution [or "turnover"], it's really significant because you're dealing with smaller-cap stocks," which are more expensive to sell in the first place, says Mindel. How significant? In one of the higher estimates, NYU professor Antti Petajisto predicted that annual reconstitution costs for the small-cap Russell 2000 were between 38 and 77 basis points and between 21 and 28 basis points for the S&P 500. So while these costs lower investor returns significantly more than many low expense ratios, they are difficult to quantify and remain invisible to most investors. Some fund families, such as DFA, reduce index turnover costs by allowing their traders to sell or buy a stock on their own timetable.

5. Expense ratios are not static.

What investors have to keep in mind, especially with a fund family like Vanguard that offers flexible expense ratios based on costs, is that expense ratios can rise and fall. According to Vanguard Spokesman John Woerth, the 7 basis points that it offers investors with at least $10,000 in their Vanguard 500 Index fund could rise if costs exceed revenue due to a dip in the market or a large-scale selloff.

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