Picking the Best Index Fund

Be vigilant when it comes to fees, Morningstar advises.

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Index funds may be boring, but therein lies their beauty. Says fund tracker Morningstar, "Unlike [with] actively managed funds, investors don't need to worry too much about their manager departing or their strategy veering off course."

Finding the best index fund takes a lot less legwork than finding the best actively managed fund. For index funds, Morningstar offers the following advice:

When in doubt, pick the cheapest fund: "If two funds practice the same strategy in the same category and have equally skilled managers, the lower-priced one will likely edge past its competitor over the long haul." Even seemingly small variations in fees can make a considerable difference, Morningstar says: "For example, a $10,000 investment in Victory Stock Index, which charges 0.81 percent for exposure to the broad-based S&P 500, would have grown to $10,906 since its mid-1999 inception. The same amount invested in Vanguard 500 Index, which charges 0.15 percent, would have grown to $11,579 over the same period."

Be aware of hidden costs, such as frequent trading: "Fees aren't always captured in the expense ratio," says Morningstar. "Transaction costs, which reduce the return from a trade, come in the form of brokerage commissions and market impact costs.... The more trading, the more the transaction costs can grow." To see how frequently a fund trades, check out its annual turnover (on Morningstar, you can find it under "portfolio," near the fund's top 25 holdings). If the number means nothing to you, compare it with those of similar index funds.

Be skeptical of quirky or gimmicky-sounding funds: "The theory is that investors expecting certain industries to boom and bust will be able to use these slivers effectively, but, like many theories, that one doesn't often work too well in reality," Morningstar says. "It seems for every good indexing idea, there are four more questionable ones, so take a close look at the underlying index construction. For most investors, it often makes sense to opt for a broad-based index fund whose success isn't dependent on the accuracy of your market-timing."

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