Large-Cap Index Funds Aren't Created Equal

Not to state the obvious, but it's been nearly impossible to hide from the horrendous side effects of the credit crisis. Both aggressive and conservative investors alike have seen their portfolios get whacked in 2008.

That may come as a (painful) surprise to that latter category of investors -- the folks who put a majority of their savings into no-frills index funds. After all, fans of index funds aren't worried about hitting it out of the park by investing in a hot mutual fund category. Instead, they can sleep at night knowing they're getting at least market returns while paying rock-bottom fees.

This week the SmartMoney.com fund screen takes a look at one of the mutual-fund world's most popular plain-vanilla options: large-cap index funds. In order to do that, though, we have to break with tradition. We could have limited our list to the 178 index funds that track the Standard & Poor's 500 index. But these days there are plenty of competing options, from "total stock market" funds to ones that focus on Russell indexes to those that "equal weight" benchmarks or use a so-called fundamental indexing strategy. We couldn't leave these funds out of the equation.

So below we have broken out a few of the major large-cap index funds in each of the categories we just mentioned. We aren't putting our stamp of approval on one over any other. Rather, we think it's interesting to see how some of these funds have performed given the recent downturn vs. their long-term track records. You might be surprised at how the subtle differences between them can impact performance. When it comes to index funds -- a type of product you're supposed to hold for decades in your portfolio -- even half a percentage point can make a big difference.

In the past, the main reason for picking one index fund rather than a competitor came down to fees. After all, S&P 500 index funds all invest in the same 500 companies, hence their gross returns will be identical. The only variable that sets them apart is the fee the sponsor company charges on an annual basis.

For example, let's assume you get a $1,000 gift for graduating college and you use that money to invest in an S&P 500 index fund you will hold for the next 45 years until retirement. If you invested in one that charged a 0.35% annual expense ratio you would pay $2,453 in fees over that time period and, at the end, you would be sitting on $62,251 (assuming a 10% average annual return). Now, if you had picked a fund that charged 0.15% a year you would have paid less than half the fees over those 45 years and your original $1,000 would have grown to $68,129. A $6,000 difference doesn't sound like much. But remember, as you contribute to your nest egg over the years, that figure will balloon.

Now, though, the mutual fund industry has come out with index products that are forcing many investors to look well beyond a simple fee calculation. The S&P 500 index is a market-weighted benchmark. In other words the bigger a company's market capitalization the larger weighting it receives in the index. An equal-weight version of that index gives the same 0.20% weighting to each and every company. A so-called fundamental index uses factors like sales, book value and dividends to rank its member companies. There are also index funds out there that focus on dividends (WisdomTree), revenues (RevenueShares), small and midsize companies and overseas firms, too.

The differences between these methodologies boil down to two details: weightings and member companies. There may be just a narrow 0.05% or 0.1% difference between some of the positions in one benchmark vs. another. But if those more heavily weighted stocks take off it can add up, especially over a portfolio of 500 companies. Other benchmarks, like the Russell 1000 or the fundamental index, have more exposure to smaller companies. That could help these benchmarks when those companies are in favor.

A few final notes to consider: We didn't exclude index funds that charged a sales load since the idea behind these funds is to hold them for the long haul. (A load would be easily washed over a decade or two holding period.) We also looked at exchange-traded funds. Unique index products are being launched in an ETF structure.

The Criteria: Below are five large-cap index fund subcategories. We have listed prominent funds in each niche. We aren't signing off on these funds as the best of breed. Rather, we think the takeaway here is to see how different indexes have performed during the recent credit crisis. Load funds and high-minimum funds are included in the mix this week.