Not All S&P 500 Index Funds Are Created Equal

May 15, 2003 — Mutual funds investing in the Standard & Poor’s 500-stock index still dominate the universe of index-tracking portfolios, or tracker funds, as they are sometimes known. At the end of 2002, a weighty $840.9 billion in assets was parked in the S&P 500, although that figure was below a record $1.2 trillion reached at the end of 1999.

At first glance, one might think that one S&P 500 index fund is pretty much the same as another. However, when evaluating such portfolios, one can go a step further and examine the fund’s tracking error and operating expenses. These two factors can affect the fund’s performance and its attractiveness as an investment over time, either on its own, or in the context of a larger portfolio of funds.

Tracking error measures the difference between the index fund’s returns and the benchmark’s return over a given period. Typically, a low tracking error implies the fund is doing a good job in keeping pace with its benchmark index, which is the desired result. In short, tracking error is primarily caused by fund expenses and transaction costs, cash balances to meet redemptions, and the mechanics and difficulties of trying to match the fund’s holdings to the index, i.e. trading and rebalancing.

Trading strategies and portfolio construction, in fact, can either minimize or maximize tracking error between the fund’s portfolio and the benchmark index. For example, a fund may be attempting to fully replicate the index by purchasing all its securities in the correct weightings, or by buying a representative sample of stocks in the index. The later method is typically not likely to track the benchmark index quite as closely.

What’s more, a large asset base for an index fund can ensure economies of scale when it comes down to fees and meeting shareholder redemptions, while funds with a lower asset base may possibly have to sell securities to meet redemptions, affecting how well the index is tracked. Funds that buy and sell large amounts of a company’s stock may also realize reduced commissions on such transactions, versus funds that only buy a few shares.

While there may not be enough of a material difference among tracking errors for the majority of S&P 500 index funds to cause real concern among retail investors, it is something to be aware of in the final analysis. Those buying index portfolios for the long term, however, would want to look closely at a fund’s expense ratio.

Srikant Dash, an index officer at Standard & Poor’s, notes that if a small investor is seeking to purchase an S&P 500 index fund, or any index fund for that matter, he would be best off putting money into a portfolio with the lowest expense ratio.

Other things being equal, higher fees on index funds eat into performance, consequently affecting tracking error. Those expenses, more meaningfully, can translate into large differences in real returns over time, or what an investor actually ends up putting in his pocket during the course of holding the investment. The higher the expense ratio on nearly identical portfolios, the lower the real return.

For example, while expenses among index funds are low on average — 0.62% — choosing an even lower cost fund, such as the Vanguard 500 Index/Inv (VFINX), which charges 0.18%, would reap almost an additional $5,500 over the average S&P 500 index fund over a 20 year period, assuming each fund gains 10% a year on a $10,000 investment.

When comparing the Vanguard fund to the Mason Street Fds Index 500 Stock Fund/B (MISBX), which has a 1.50% expense ratio, the difference becomes even more dramatic: Over the same time period, investors in the Vanguard fund would reap over an additional $15,000. Looking at it another way, the projected return at the end of the 20-year holding period is $64,894 for the Vanguard fund, versus $49,725 for the Mason fund.

Fund Advisor identified 65 index funds — out of a universe of 72 tracked in our database — which invest in the S&P 500 and have at least three years of operating history. The tables below show the five funds with the lowest and highest annualized tracking errors for the three-year period ended March 31:

FUND*TRACKING ERROR (%)

Dreyfus Index Fds:S&P 500 Index Fund (PEOPX)0.06

Dreyfus BASIC S&P 500 Stock Index Fund (DSPIX) 0.07

Vanguard 500 Index/Inv (VFINX) 0.08

Munder Funds Index 500/A (MUXAX) 0.08

One Group Equity Index/A (OGEAX) 0.08

FUND*TRACKING ERROR (%)

Scudder Select 500 Fund/S (SSFFX)2.31 (closed to new investors)