5 Questions Worth Asking About Your Index Fund

Note: This article is part of Morningstar's April 2015 Active, Passive, and In-Between special report.

Some investors look at index funds the way most of us look at sheet cake at a birthday party: It's good--but once you've tried one, you've tried them all.

The fact is, though, that index funds are not all the same, even those that track the same index. While differences among index funds may not be as stark as those among actively managed funds--discussed yesterday in this article--index-fund investors still need to understand what makes some index funds better than others. And with more money flowing into index funds each year--Morningstar data show that investors poured $420.1 billion into passive funds in 2014 compared with just $44.3 billion flowing into actively managed funds--these distinctions apply to more investors than ever before.

Whether your portfolio is made up entirely of index funds or just partly, the following questions can help you determine whether you've chosen wisely.

Question 1: Is there a cheaper option?
Among the most compelling reasons for choosing index funds over actively managed funds is that they tend to be cheaper--much cheaper. On an asset-weighted basis, equity index mutual funds charge just 12 basis points (0.12%), on average, versus 0.84% for the average actively managed mutual fund. On the fixed-income side, it's the same story, with the average bond index mutual fund charging 0.10% (again, asset-weighted) versus 0.62% for the average actively managed bond mutual fund. Although you shouldn't choose an index fund based on price alone (as you'll see from the points that follow this one), it is one of, if not the, most important factors. And with index-fund providers engaged in a long-term price war over who can offer the lowest expense ratios, these are great times to be an index-fund investor.

How you can tell: Compare expense ratio, but also look at aftertax returns if you're holding the investment in a taxable account (found under the Tax tab on fund pages). Two funds may charge the same expense ratio, but if one is more tax-efficient--for example, because it is better able to avoid making capital gains distributions to shareholders--it may deliver a better aftertax return than its counterpart. For more on how funds tracking the same index can experience different levels of tax efficiency, read this article by Morningstar fund analyst Mike Rawson.

Question 2: Mutual fund or ETF?
Exchange-traded funds, or ETFs, have become an increasingly popular way to invest in an index. ETFs often have an edge in terms of expense ratio over comparable traditional mutual funds and can be more tax-efficient because of the way they handle redemptions. Plus, they allow investors to trade shares while the market is open rather than waiting until after it closes to make transactions. Yet, there are still times when owning an index mutual fund makes more sense than owning a comparable index ETF, such as for those who are investing over time rather than in one lump sum. (For more examples, read "When Mutual Funds Beat ETFs.") Be sure you understand the differences between these two vehicles when you select an index fund.

How you can tell: Exchange-traded funds have the acronym "ETF" included in the name. 

Question 3: What index does it track?
Don't assume that index funds in the same category track the same index. For example, many funds track the S&P 500, including  SPDR S&P 500 ETF (SPY),  Schwab S&P 500 Index (SWPPX), and the  Vanguard 500 Index (VFINX). But Schwab also offers a  Schwab US Large-Cap ETF (SCHX) that tracks the 750 largest U.S. stocks, giving it a slightly larger exposure to mid-cap stocks, even though it and the S&P 500 funds all land in the large-blend category. Likewise, many foreign index funds track MSCI indexes, but Vanguard's foreign-equity funds track FTSE indexes. One key difference: FTSE counts South Korea as a developed market while MSCI counts it as an emerging market. 

How you can tell: Read the index fund's prospectus closely to find out what index it tracks, or read the Fund Analyst Report (Premium Membership required). It's also a good idea to look at the fund's portfolio (under the Portfolio tab) to check out allocation, sector, and regional weightings. You can even use the drop-down menu at the top of the page to compare the index fund's allocation and weightings with those of other indexes.

Question 4: How well does the fund do its job?
Of course, an index fund's job is relatively straightforward: Track an index as closely as possible. Yet, some do this better than others. So-called "tracking error" refers to gaps in the performance of an index fund relative to its benchmark. Because index funds cost money to run, some tracking error naturally results from subtracting these expenses from the fund's performance. Yet, some funds find ways to limit this error--for example, by loaning out securities from their portfolios in order to make money to help offset expenses. Another way index funds can limit tracking error is by limiting their use of sampling, a method used by some index funds to approximate the performance of hard-to-buy securities--such as the stocks of very small companies--rather than owning each of those securities individually. 

How you can tell: Check the fund's performance relative to the benchmark, and relative to its competitors that track the same index. If your fund's performance tends to vary more widely than its competitors', this means that tracking error is a problem--even though the fund could end up performing better than the competition and even the index because of it. Fund Analyst Reports also may tell you if tracking error is a problem or about steps the fund takes to reduce it (Premium Membership required).

Question 5: What role does the fund play in your portfolio?
As with active funds, an index fund should fill a specific need in your portfolio. The good news here is that, unlike with active funds, performance should be rather predictable--you can expect close to the index's return no matter what happens. However, just because you own an index fund doesn't necessarily mean you are well diversified. If your portfolio consists of only value index funds (large value, mid-value, small value), you may be neglecting growth stocks that could offer better performance under certain circumstances. Likewise, if you own a total-market index fund along with a small-cap index fund, you should be aware that you are messing with the basic framework of an asset-weighted indexing approach--that is to say, you are holding a heavier allocation to small caps than you may realize. 

How you can tell: Use Morningstar's portfolio X-Ray tools to make sure your overall allocation meets your needs. You can drill down further by selecting the X-Ray Details tab to see which funds in your portfolio are providing what kind of exposure. This is particularly useful if you are mixing active and index funds in your portfolio, as the exposure provided by your active funds may be less obvious and you may want to avoid duplicating it through your index holdings.