Ivy Leaguers Missed the Point: Low Expenses Key to Index Funds

Lynn O'Shaughnessy

5/2/2006 2:16:16 PM - Lynn O'Shaughnessy

If you had been brilliant enough to get into an Ivy League school, do you think you would be a wiser investor today?

The answer is probably no. Ivy Leaguers may know how to separate DNA and write a cogent essay on the rich symbolism in Anna Karenina, but in a recent study, the brainiacs bombed miserably on - get this - an open-book test.

The study, which was designed by three professors from Harvard, Yale and the University of Pennsylvania, examined whether highly educated people could figure out how to correctly pick an index mutual fund.

You'd think this would be a slam dunk, especially since the experiment's guinea pigs were Ivy League undergraduates, as well as graduate students who were almost all enrolled in the MBA program at Penn's Wharton School, which is famed for its business programs.

When they applied to college, the MBA students received average SAT scores that vaulted them into the 98th percentile of test-takers, while the undergraduates did slightly better. No slouches in this cohort.

The professors gave each of these overachievers a hypothetical $10,000 and told each one to invest in one or more index funds. They could divide the money any way they wanted among four fund choices, or sink it all into one. All the funds were linked to the Standard & Poor's 500 Index, which means each fund invested in the same 500 blue-chip corporations.

You may think that choosing the superior investment among four funds that invest identically would be like ripping open a package of No. 2 pencils and picking the best one. The study, however, offered a clear choice. And the experiment's designers did everything short of pointing a giant flashing neon arrow at the right answer.

The students were given all the background materials they needed to ferret out the superior fund, including a one-sheet handout on each fund's expenses. They also were expected to read through each prospectus, an admittedly stultifying document.

Ultimately, the students flunked their challenge by focusing on stuff that was as relevant as yesterday's surf report. The amateur investors seemed convinced that what mattered most was the investment equivalent of box scores. Many of them placed the greatest weight on the cumulative performance of each fund. The funds, however, were launched at different times, which means the running performance tally was meaningless.

Our bookish investors appeared oblivious to what really matters when picking index funds: low expenses.

One fund clearly was cheaper than the rest and should have been the only one the students selected. In the index-fund experiment, one group of the test-takers listed fees as a mere eighth out of 11 factors to consider when choosing a fund.

"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.