How to evaluate index and passive funds

When choosing index or passive funds, the expense ratio shouldn't be the only consideration.
Flickr user 401(K) 2012

(MoneyWatch) Index and other passively managed funds have been slowly gaining popularity among investors. However, comparing similar index funds can be difficult and goes beyond simply looking at the expense ratio.

Certainly, the expense ratio is a big consideration, but it's important to look at what you're getting in return. With index funds, you're not only looking for low-cost exposure to the market, but also individual market factors, such as the size and value factors. (These factors show how much exposure the fund has to the size and value premiums, which are the higher expected returns of small-cap and value stocks.)

For example, just because one small-cap value fund is cheaper doesn't automatically mean it's the better choice. If the other fund has more significant exposure to the size and value factors, it may be the better fund for your portfolio. 

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As an example, let's look at two such funds: the DFA US Small Cap Value Portfolio (DFSVX) and the Vanguard Small-Cap Value Index (VISVX). The table shows the funds' expense ratios and their degrees of exposure to the market, size and value premiums for the period June 1998-December 2011 (the period since the Vanguard fund's inception).

The point isn't to say that one fund is better than the other. The lesson here is that not all passive funds are created equal, and you shouldn't simply look at the expense ratio and end the evaluation. Instead, determine how much exposure you need to the market, size and value premiums and find the least expensive way of getting that exposure.

Image courtesy of Flickr user 401(K) 2012

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    Larry Swedroe is director of research for The BAM Alliance. He has authored or co-authored 13 books, including his most recent, Think, Act, and Invest Like Warren Buffett. His opinions and comments expressed on this site are his own and may not accurately reflect those of the firm.