One of the largest misconception about index funds is that their only distinguishing feature is their fees. It's not uncommon to hear, "index funds are just holding the stocks or bonds in the index, so we don't need to pay attention to them." This assumption, however, is an oversimplification. Many investors don't realize that all index funds are not created equally.
A key difference between indexes and index funds is that index funds are exactly that - funds. Index funds manage obstacles that indexes themselves don't face. The largest is that funds actually must transact in securities whereas indexes do not.
As an example, when Standard and Poor's recently added Coty (COTY) to the S&P 500 Index to replace Diamond Offshore Drilling (DO), S&P simply recalculated the index values based on the closing prices of the securities on the effective date. Index funds that track the S&P 500, however, had to sell out of their positions in DO and purchase COTY, PLUS rebalance the weightings of any remaining securities that were impacted by the change. Trading in these securities exposed the funds to transaction costs such as commissions and market impact. Additionally, funds face the risk that their realized trade prices on the securities may be different than the values used to calculate the index, creating a difference in performance. In this example, the impact of these factors is generally small.
Where the impact is more meaningful is in areas such as fixed income and international equities where liquidity in the securities tends to be significantly lower, there are more securities in the indexes, and changes are more frequent. The Barclays Aggregate Index, for example, has over 8,500 securities in it, with many of them not trading every day. In addition, the index rebalances on a monthly basis, so managers tracking this index must constantly adjust the fund.
Index funds must also efficiently manage flows in and out of the funds, dividends and interest payments, mergers, tax consequences and securities lending - all challenges that the underlying indexes do not face.
Fortunately, most index managers are adept at keeping their funds in-line with their benchmarks, so the impact of these factors on fund performance is generally small - small, but important. Just like active funds, evaluating index funds requires careful analysis beyond fees and should also include performance and risk. The index fund metrics in the Scorecard System™ incorporate all of these, providing a complete picture of the factors that produce the most effective index funds.