Understand the Gamble of Index Funds

Physician's Money DigestDecember 2005
Volume 12
Issue 16

Should we get ready for indexmutual fund price wars? Notexactly, but the growing popularityof these investmentvehicles has some competingfund companies taking serious steps.But before you invest your money in afund that simply mirrors the S&P 500Index, physician-investors should beaware of a few things.

Fees Outweigh Gains?

Over the past 10 years, the S&P 500has averaged annualized returns of10.7%, compared with 8.6% foractively managed large cap funds, andhave averaged 12.8% and 11.1%,respectively, over the past 20 years. Areason for the difference is that indexfunds buy and hold stocks within theindex they track, which makes themless expensive to run. Most blue chipfunds take an average of more than onepercentage point a year out of returnsbefore they make a trade.

However, not all index funds are createdequal. According to a study conductedby the Consumer Federation ofAmerica and Fund Democracy, theaverage S&P 500 Index fund charges0.82% or more than some activelymanaged funds, which can make a bigdifference even in a short period of time.

Suppose you invested $20,000 intothe class A shares of the MorganStanley S&P 500 Index in 1997, whichcharges 0.70%—plus an up-front salesload. You would have about $1100 lesstoday ($24,620 vs $25,720) than if youhad invested the money in the Vanguard500 Index.

Pay More for the Same


Even though you may be payingextra for an active fund manager, youmight end up owning the same companiesthat are in the index. According to, when funds do well and attractmore cash from investors, they haveto buy more stocks. Invariably, investorsend up owning many of thebig stocks that are in the S&P 500Index, and end up paying more for anactively managed fund that bears astrong resemblance to an index fund.

Keep in mind, however, that theS&P 500 represents only 77% of thevalue of all US stocks. There are approximately4500 smaller companiesto be considered. The Vanguard TotalStock Market Index tracks the DowJones Wilshire 5000, which includesboth small and large cap companies.These funds offer maximum diversificationfrom a single investment source.

As Risky as the Sector

Because index funds in many waysmirror the market segments they follow,they are also susceptible to risk.As the article explains, companies listedon the S&P 500 automaticallyassume a bigger portion of the indexas their market value increases. Themore popular a stock is, the more of itan index fund will own.

For example, when the tech and telecombubble burst in 2000, the Vanguard500 had 39% of its assets intech-type stocks, contributing to a 37%drop in value over the next 2 years.Similarly, by the time the market bottomedout in 2002, the fund held only16% of its assets in those areas, provingthat an index fund is generally nosafer than the sector it follows.

It's important to remember thatwhile investing in index funds has itsadvantages, there are no guarantees.Doing your homework prior to makingany investment decision is the bestcourse of action.

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