So you want to pick an index fund. But there are thousands of options to choose from!
Where do you start? And how do you decide which index fund to invest in?
Here are the questions and criteria I use to pick a good index fund. Why they matter. And some rules of thumb that you can use to quickly filter the good from the bad.
Criteria for selecting a good index fund
When I’m looking at an index fund, I ask these 7 questions:
- Is it actively or passively managed?
- What does it invest in?
- What is the expense ratio?
- How long has it been around?
- How well does it track its benchmark?
- How liquid is it?
- How is it taxed?
Then I compare the results with similar funds to decide which one is right for my portfolio.
Notice that I’m not looking for a fund that outperformed the index. That’s what Morningstar does when it ranks funds. But ranking a fund based on its recent performance is a bad way to pick a fund. Funds that outperformed in the past tend to underperform in the future!
This article explains just how hard it has been for funds to consistently outperform their benchmark index over time.
Let’s walk through each question to see how it will help you pick an index fund.
Is it active or passively managed?
An actively managed fund is one where humans are working to pick stocks that they think will do better than the benchmark for some reason.
Passively managed funds simply try to match the index. They don’t worry about beating it.
There are also semi-active funds from companies like Avantis and DFA. These companies use computer algorithms to filter the index, and keep only the stocks that meet the algorithm’s criteria. They believe this will cause their funds to beat the index over time, and have had some impressive results so far. But they haven’t been around long enough to really know how well they work long-term. And they’re not true index funds because of this method.
If you believe that the management team of an active or semi-active fund has a good method for picking stocks that will outperform, you might want to go that way. But pure index fund investing uses passive funds. It doesn’t try to find the best stocks within the index.
So if you want to be an index fund investor, stick with passive funds. They have the lowest costs and come closest to matching the index that they track.
What does it invest in?
This might sound obvious for an index fund. But there are thousands of indexes in the world. Almost every asset class has several indexes to choose from. And the more popular the index, the more funds there are to track it.
So you need to start by knowing which index you want to invest in, and why. Then make sure the fund you pick is specifically tracking that index. Not just something “similar”. Unless you know it has the diversification, long-term performance, and correlation with other parts of your portfolio that fits its needs.
The most popular indexes in the world are the S&P 500, Dow Jones Industrial Average, and Nasdaq Composite.
If you want to invest in large US companies, all 3 of these technically do that. But the S&P 500 does it in the broadest way, by holding the 500 largest companies in America. The Dow holds just 30 giant companies. And the Nasdaq holds more than 3,700 companies; more than half of them are technology stocks. So they all perform differently, and you want the one that matches your goals for your portfolio.
What is the expense ratio?
For passive index funds that track the same index, the best indicator of performance is expenses.
Picking an index fund isn’t like picking a hotel, where you get what you pay for. Paying more for an index fund doesn’t mean you’re getting a better product. It’s more likely to mean the opposite!
The expense ratio is the percentage of fees that the fund charges each year. If you have $1,000 invested and the expense ratio is 0.23%, the fund will take $2.30 in fees.
If the expense ratio is high, it will drag down the returns on an index fund.
There has been big competition over expenses in the past decade. And that’s great for investors!
Some index funds have fees under 0.1% now. Fidelity even has a line of index funds with 0% expenses!
For most indexes, if the expense ratio is above 0.25%, I wouldn’t consider it. Expenses are generally higher for international index funds and some of the less popular indexes that take more effort for the fund company to construct and manage. But you may still find a fund that breaks that rule in order to get your business.
It’s worth noting that some funds also come with a “load”, which is a one-time fee that you pay every time you buy (front-end loaded) or sell (back-end loaded) it. These fees are used to pay commissions to salespeople. They used to be more common. But you should never need to pay a load anymore. Stick with No-Load — also called No Transaction Fee — funds.
How long has it been around?
The age of a fund is more important for active than passive index funds. But I mention it here because of the next question. If a fund has only been around a year or two, it’s hard to tell how well it tracks the index it invests in. It’s usually better to pick an index fund that has been around at least 5 years.
An exception might be when the fund company has been making index funds for decades–think Vanguard, Fidelity, iShares, or Blackrock–and has just introduced a new, lower cost version of an older index fund. This is done sometimes to attract new customers.
How well does it track its benchmark?
After checking how long the fund has existed, you’ll want to see how well it does at tracking the index.
On most sites, you can look at a 1-year, 5-year, and 10-year table or a plot that compares the fund to its benchmark index. It will underperform the index by its expense ratio plus or minus a tracking error.
Tracking error for the biggest index funds is under 1%. The smaller and more specialized the index, however, the more tracking error you can expect. For small-cap index funds, for instance, you’ll see tracking error on the order of 11%. The sub-category of small-cap value has larger tracking errors around 14%. In these cases, you’ll have to:
- Compare tracking error of several funds in the same category
- Decide if the index is still worth investing in
- Pick a fund with relatively low tracking error for its category
How liquid is it?
Liquidity is your ability to buy and sell shares on demand. When you’re selling to rebalance or take income, you want there to be a buyer on the other end. Otherwise, you might have to wait to get your money or get paid less than your shares are worth!
This factor is most important to someone who’s drawing a regular income from their investments. It might also be important if you’re buying or selling large amounts of the fund all at once, or if you want to rebalance often.
There is no one way to measure liquidity. Here is the method that I have found useful:
What is the fund’s trading volume vs. total assets?
First look at Assets Under Management (AUM). This tells you how much money is invested in the fund itself. If AUM is under $100 million, that’s a tiny fund and there might not be many transactions in a day. The biggest funds have over $100 billion in AUM.
Smaller funds generally have more liquidity because the entire fund could be sold and absorbed into the market without a big impact on overall market prices.
Then look at Average Daily Volume (ADV) of trading and take the ratio of ADV to AUM as a percentage. High trading volume gives a fund more liquidity, and vice versa.
Lower liquidity funds trade less than 0.5% of assets in a day. Higher liquidity funds trade over 1% daily.
If trading volume is low, a higher amount of cash on hand could make it easier to get your money out too. Index funds keep most of their cash deployed, though. So you won’t find many funds with lots of cash sitting around.
Large-cap index funds—both US and International—generally don’t have liquidity problems because there are many more shares of large companies to redeem. So don’t worry about liquidity for those. Instead, pay attention to small-cap and micro-cap index funds.
The smaller the companies that an index fund invests in, and the more money it has under management, the less liquid it is. If everyone wanted their money at the same time, the fund might not be able to sell enough shares of those companies to give it back. But if the trading volume is high, the fund might find other buyers to take your place. In that case, it wouldn’t need to sell the underlying shares.
What are the tax implications?
Tax efficiency only matters if you hold the fund in a taxable account. So this question goes toward asset location. But it’s worth mentioning here since many readers at PathwayToFI are big savers. After maxing out tax-advantaged accounts, additional investments will be in a taxable brokerage. Read Put Your Retirement Savings in These Accounts First for more on which accounts your investments should be in.
For tax-advantaged retirement accounts—IRA, 401k, HSA, etc.—you don’t have to worry about this.
For taxable accounts, though, you want to know how dividends are taxed, how often shares are bought and sold within the fund, and how internal share sales are taxed.
Are you taxed when other investors sell shares?
This is only a problem for some mutual funds. Exchange-Traded Funds (ETFs) can get around it. Both ETFs and mutual funds can be index funds.
For many mutual funds, when an investor wants to sell shares of the fund, the manager has to sell stocks. That triggers a taxable event, unless it’s done as a swap. Vanguard has a patent on a method to avoid this for their mutual funds. But the 20-year limit on patent protection ran out 2023, so other companies will be doing this soon enough, and won’t be an issue after that.
The safest bet for now is to choose ETF index funds for taxable accounts.
Are dividends and interest qualified or unqualified?
Check what portion of dividends are qualified versus unqualified.
Qualified dividends and interest are taxed at long-term capital gains rates if the shares have been held for at least a year.
Unqualified dividends and interest are taxed as regular income, which is a higher rate.
Ideally, all your taxable investments will pay qualified dividends. You can hold investments that pay unqualified dividends and interest in your tax-advantaged accounts.
Examples of unqualified dividends and interest are REITs (Real Estate Investment Trusts) and most bond funds.
What is the turnover?
A fund’s turnover rate tells you how often positions are added and removed from the fund.
For a passive index funds, turnover should be less than 20%. Small-cap index funds have higher turnover, though, since small companies often outgrow the index and are replaced by others. They also go out of business more often than large companies.
Every time a fund sells shares internally, it triggers a taxable event for the investor.
That’s why taxable accounts should generally hold low turnover funds.
However, there’s a more direct way of looking at tax consequences from dividends, interest, and capital gains. That’s called the Tax Cost Ratio.
What is the Tax Cost Ratio?
If you only look at one factor for taxes, this is it!
Tax Cost Ratio is the amount that a fund’s return could be reduced by each year due to taxes.
This number is calculated and given to you by major companies like Morningstar and Fidelity, where you’ll do your research. It assumes the investor is in the highest income and capital gains tax brackets. So if you’re in a lower bracket, you won’t pay the full tax cost given by this ratio.
Tax Cost Ratio might be the most important number you use to pick an index fund for a taxable account. It takes all the other tax factors into account.
If you’re in a high tax bracket, it can be even more important than the expense ratio. Good Tax Cost Ratios are 0.5% or less. Typical numbers for index funds can be around 1%, though, depending on what the index holds.
Summary
There are many great index funds to pick from today. Some are so similar in performance and expenses that it really doesn’t matter which one you pick. In that case, you can just go with the fund company that you prefer. Or flip a coin.
But first you need to find out whether it matters or not. And that may depend on your tax situation or how important liquidity is to you.
Here are some simple rules for how to pick a good index fund:
- Stick with passively managed funds.
- Make sure it invests in the exact index that you want to invest in. Not some proprietary index, for instance.
- Pick a fund with a low expense ratio for its category. Don’t use anything over 0.25%.
- Pick a fund that’s been around at least 5 years, unless it’s just a lower-cost version from a well-established fund company.
- Pick a fund that has tracked its index with low tracking error relative to similar funds.
- Pick a fund with good liquidity relative to similar funds, as measured by the ADV/AUM ratio.
- If the fund will be held in a taxable account:
- It should ideally pay qualified dividends
- It should have relatively low turnover
- Most importantly, it should have a relatively low Tax Cost Ratio; ideally less than 0.5%.
These guidelines will help you put together a great portfolio!
Read these articles next for ideas on how to construct your portfolio and which accounts to hold it in:
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