What to look for in an index fund besides low fees
By Pavel Cherkashin
In a recent post, we explored why the index strategy has been the most successful approach to the traditional financial market and argued that applying this strategy to the highly unpredictable cryptocurrency market makes a lot of sense. Just as a venture investor would never bet on just one startup, a crypto investor should not count on just one cryptocurrency — especially now, when the whole market is a venture.
But what should you look for when choosing an index fund? In this post, we’ll list the key things to look for.
Smaller fees are the biggest selling point
Index funds typically offer smaller fees than other trading hedge funds. And the larger an index fund is, the smaller its fees, because once the fund has developed an index strategy, is has only to automatically follow it from then on. Moreover, there are plenty of index funds that don’t even bother to develop their own strategy. Instead, they simply use well-known indexes, such as the S&P 500 (on the traditional markets) or just take top X currencies based on the market cap without considering other factors (on the cryptocurrency market). Even though both exchange traded funds (ETFs) and mutual index funds are not actively managed by professionals with high salaries, mutual index funds usually have slightly higher fees than ETFs.
Given that all index funds offer fairly low fees, what else should investors look for when selecting a fund?
There are financial factors beyond fees that you should keep in mind. These include:
· Administrative costs. The administrative costs of the fund are subtracted from each shareholder’s return as a percentage of their overall investment. The expense ratio can be anything from 0.1% to 1%.
· Taxes. Capital gains taxes can be a few tenths of a percentage point, so investors need to understand whether the fund is held in a taxable account or in a tax-advantaged accounts like a 401(k) or IRA. ETFs are usually more tax-efficient than mutual funds. Even though investment managers do not advise their clients about taxes, some funds are structured and optimized to accommodate the needs of investors from various tax jurisdictions.
· Minimum investment contribution and minimum additional investment. These can be as low as a few thousand dollars or as high as hundreds of thousands of dollars.
· Expected return. In many cases, a fund’s expected return is shown without deducting possible costs, fees and taxes. Customers should keep this in mind when comparing the promises of various funds.
Besides the financial consideration, there are a few other things investors should weigh when choosing an index fund, such as:
· Flexibility for investors. Check whether there is a minimum lock-up period or whether monthly withdrawals and additional deposits are allowed.
· Index methodology. The index methodology must be absolutely transparent and rigorously followed by the fund. If a fund was launched recently, it may be hard to verify whether the strategy is followed, since the fund can show only the backtesting results.
· Fund performance. Historical data about fund performance alone doesn’t say much, though a bad track record should give one pause. Instead, the past and current results should be compared with the performance of the benchmark index. When analyzing a new fund, investors should look into strategy validation and review the backtesting results.
· Fund reliability. When choosing a fund, investors should do a background check: Determine who the managers and the team are, what experience they have, and who the fund works with. Make sure that the fund works with one of the top fund administrators, because the fund administrator not only carries out certain functions for the fund but also verifies the transparency and lawfulness of transactions, and sometimes serves as a third validator of fund operations. Another question to ask is whether the fund is audited.
· Fund size. Fund size is indicative of how much other investors are interested in the fund and its strategy and believe in its management team. A strong management team can efficiently raise and manage investments, and the larger the investments, the greater the operating leverage.
· Reporting. It is worth checking whether the fund provides regular and easy-to-read reporting on time.
· Responsiveness. Fund managers should be able to easily answer questions and provide requested information. If they struggle to do so, it is a sign to question their expertise and skills and therefore whether it makes sense to invest with them.