"When we make fund fees salient and transparent, subjects' portfolios shift towards lower-fee index funds, but over 80 percent still do not invest everything in the lowest-fee fund," concluded the authors in a study entitled "Why Does the Law of One Price Fail? An Experiment on Index Mutual Funds."
Go ahead and feel smug about the Ivy Leaguers' failure, as long as you don't repeat their mistakes. Just remember what they couldn't grasp when you are investing in index funds - which is the preferable way to go: Stick with the ones that are dirt-cheap.
Costs are critical because it's what distinguishes index funds from one another. The higher-cost index funds should typically perform the worst and the cheapest ones the best. Obviously, costs are also important if you invest in actively managed funds, which I criticized last week.
If you restrict yourself to the bargain table, you will probably end up looking at index funds offered by the Vanguard Group and Fidelity Investments. Exchange-traded funds are the other cheap indexing alternative.
Fidelity Investments' index funds are slightly cheaper than Vanguard's, but the fund family's selection is far more limited and the minimum investments are higher. For instance, Fidelity Spartan 500 Index Fund, Investor Class, has an annual expense ratio of 0.10 percent versus an expense ratio of 0.18 percent for Vanguard 500 Index Fund, Investor Shares. But you need $10,000 to initially invest in Fidelity's index funds versus $3,000 for Vanguard.
Both fund families offer even lower prices for investors who can sink $100,000 into a single fund.
Frankly, when investing in index funds, analyzing funds by their price tags should be the easy part. What's trickier is how to patch together a portfolio of inexpensive funds. After last week's column on the superiority of index funds, readers e-mailed me questions that illustrate how confusing it can be for even the most conscientious investors to proceed. One reader was eager to know whether she should sink all her money into the very best index fund. And, she wondered, what fund has earned that distinction. Others wanted lists of the top index funds.
Unfortunately, the index world doesn't possess a silver bullet. The most popular index fund in America is Vanguard 500 index, but that doesn't mean it's superior to other low-cost options. Instead of fixating on one fund, investors should first concentrate on dividing their money into basic asset classes.
After finishing that task, you should figure out what index fund to plug into each investment category. If you prefer keeping it really simple, you could divide your cash among index funds that invest in four basic asset categories: large-cap domestic stocks, small-cap domestic stocks, foreign stocks, and a short-term or intermediate-term bond index fund.
Vanguard and Fidelity offer index funds for those broad categories.
More sophisticated investors may want to slice the pie into more pieces. They may want to add a REIT index fund or an index fund that invests in Treasury Inflation Protected Securities. Some investors might decide to invest a small portion of their portfolio in an emerging market stock index fund. Others will want their portfolios to lean more heavily toward growth or value. Vanguard, for instance, has large- and small-cap index funds that invest exclusively in either value or growth stocks.
To learn more on how you can devise your own asset allocation, I suggest that you read one or more of the following books on the topic: "The Four Pillars of Investing, Lessons for Building a Winning Portfolio" and "The Intelligent Asset Allocator," by William Bernstein; "The Only Guide to a Winning Investment Strategy You'll Ever Need," by Larry E. Swedroe; and "All About Asset Allocation, The Easy Way to Get Started," by Richard A. Ferri.