Are Retail S&P 500 Index Funds a Financial Commodity? Insights for Investors

Abstract

Conventional wisdom suggests that index funds are commodity-like in nature. If this presumption is accurate, price competition should be more evident with index funds than with actively managed funds. Thus, expenses should not vary widely among index funds using the same benchmark. In this paper, we investigate whether retail S&P 500 Index funds are a financial commodity. Specifically, we test whether expenses matter more for retail S&P 500 Index funds than for actively managed funds. Our analysis of 106 retail S&P 500 Index funds shows a wide disparity in (net) expense ratios. In addition, we find large performance differences among funds within diverse (net) expense ratio classes. Based on this evidence, we conclude that retail S&P 500 Index funds with low (net) expense ratios, on average, outperform those with high (net) expense ratios. Specifically, our univariate analysis shows that Sharpe ratios and Jensen alphas tend to increase as (net) expense ratios decline across standard deviation classes. Thus, lower (net) expense ratios result in improved risk-adjusted returns. Retail S&P 500 Index funds with low (net) expense ratios also tend to have higher annualized returns compared with those with (net) expense ratios that are high. Thus, lower costs mean larger returns.

Our multivariate model provides evidence on characteristics that investors can use to explain performance. In this OLS model, we pool the funds and use dummies and interactions for testing the relative significance of variables across retail S&P 500 Index funds and actively managed large-cap blend funds used as a control group. We find evidence that (net) expense ratio class helps to explain performance. In addition, fund size is a distinguishing variable for performance. Cash holdings and portfolio turnover generally have a positive relation with performance but loads, especially deferred loads, and 12b-1 fees typically have the opposite relation. In addition, our results show that expenses do not matter more for retail S&P 500 Index funds than for actively managed funds.

What are the implications of our findings? Mutual fund investors are likely to view index funds as financial commodities because of the common belief that such funds do not differ in any significant way, especially when tracking the same benchmark index. Evidence of large differences in (net) expense ratios across index funds casts serious doubt on using "commodity" as a descriptor. Further, this finding becomes more serious because price competition should be even more competitive among index funds, especially in the pricing of (net) expense ratios. Apparently, it does not. This implies that some uninformed investors are paying high costs without receiving commensurate benefits.

This study provides an important lesson for mutual fund investors who are interested in retail S&P 500 Index funds. Namely, (net) expense ratios have a direct negative impact on performance. Low cost does not characterize all retail S&P 500 Index funds. Some funds charge fees and incur expenses that are too diverse along the range of outcomes to be consistent with commodities. Thus, when comparing mutual funds, investors should generally seek to minimize expenses because additional fees provide no apparent economic benefit.

Keywords: mutual funds, S&P 500 Index funds, financial commodities, price competition, expense ratio, performance, characteristics, standard deviation classes, retail index funds, 12b-1 fees, uninformed investors

JEL Classification: G2, G23, G28