Three ways not all index funds are the same

Among the biggest differences with index funds is the fees they charge. Funds that are otherwise virtually identical--meaning they track the same index--can nonetheless produce different returns based on their fees. That's because fund fees are deducted from fund returns. So assuming two identical portfolios, the fund with the lower fees, and therefore the smaller bite taken out of returns, will deliver a higher total return to shareholders. (Index funds also may lend out some of their holdings to generate income for the fund and thereby lower their fees.)

To illustrate, let's look at funds that track the most widely used of all indexes, the S&P 500. In Canada alone, Morningstar's database includes eight different exchange-traded funds that track this benchmark (not including multiple versions of the same funds), and dozens more that trade in the United States. There are also several mutual funds pegged to the S&P 500, with expense ratios that run the gamut. The cheapest option among the TSX-traded ETFs is iShares S&P 500 Index XUS, which recently slashed its management fee to 10 basis points (0.10%) and should have an MER in the neighbourhood of 0.11%. At the other end of the spectrum are mutual funds such as CIBC U.S. Index, which tracks the same index but charges 118 basis points--more than 10 times what the cheapest ETFs charge.

You might think this gap in expense ratios, equaling a little more than one percentage point, doesn't amount to much. After all, what's an extra $100 to pay on a $10,000 investment each year? But this cost difference has an even bigger effect on fund performance when compounded over time. Consider that $10,000 invested in the CIBC fund 10 years ago would be worth $15,556 today (as of July 15). But the same amount invested in TD U.S. Index (Series e), which has an MER of just 0.35%, would be worth $16,755. Same index, same holdings, but the cost difference resulted in a roughly $1,200 gap in performance during a decade.

The challenges of tracking an index

Although expense ratio is by far the most significant difference among funds tracking the same index, there may be others, as well. Among these are the extent to which the fund tracks its index. For example, the managers of a fund tracking a small-cap index that includes micro-caps -- stocks of very small companies that can be hard to buy -- may decide it's not cost-effective to try to own each and every stock in the index. Instead they may employ a technique known as sampling, in which the portfolio is designed to mimic the performance of the hard-to-buy stocks, using similarly behaving liquid stocks in their place. Sampling techniques can vary from fund to fund and may contribute to another key index fund difference known as tracking error.

Tracking error is the degree to which an index fund fails to mirror its benchmark's performance during a given time period. Sampling is one source of tracking error. The fund's rebalancing method can be another. As the components and weightings of an index change over time, the fund must buy and sell holdings in an attempt to match it. Let's say a fund's sampling technique results in a slight underweighting in a handful of stocks that are in the index and just happen to have better performance. In that case, the fund's total return may not match that of the index, and the fund will now be even more underweight in those stocks, causing tracking error. In a sense, the fund's expense ratio itself creates a form of tracking error because fees are deducted from returns.

How can you tell if tracking error is at play with your fund? One way is to check its performance versus the index. The gap between the two should be close to the fund's expense ratio. If it's considerably wider -- say, 10 basis points or more -- inefficient management may be to blame. Tracking error isn't necessarily a bad thing. In fact, index funds with high tracking error may outperform those with low tracking error. And some indexes are simply more difficult to track than others. But it is generally seen as undesirable based on the assumption that index-fund investors desire index-like returns.

Subtle index differences

Another issue to keep in mind when comparing index funds within the same category is that they may not track the same index. For example, most core domestic bond ETFs track the FTSE TMX Canada Universe Bond Index (formerly DEX Universe Bond Index); however, Vanguard Canadian Aggregate Bond VAB tracks the Barclays Capital Global Aggregate Canadian Float Adjusted Bond Index. The duration of the two indexes is virtually identical at around 7.2 years, but the Universe index courts more credit risk by holding more than 30% of its portfolio in corporate bonds, while the Barclays index holds just over 21% in corporates.

These differences can get even more complex when dealing with equity funds that track indexes with value or growth tilts. That's because even though blended benchmarks typically include or exclude companies based on their market caps, indexes that focus exclusively on value or growth stocks typically apply their own proprietary screens based on variables such as company fundamentals and stock price. A company that qualifies for one value-oriented index may not qualify for another. Consequently, value- or growth-oriented index funds may have portfolios that vary from one another to a greater extent than one might find among index funds tracking a blended benchmark, especially one that includes highly liquid stocks.

Index funds tend to be rather straightforward, easy-to-own and cost-effective investment vehicles. By educating yourself about how they differ from one another, you can help make sure they perform as expected.

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