How Wall Street can make a good investment bad

How Wall Street can make a good investment bad

John Waggoner, USA TODAY7 a.m. EST January 18, 2014

Can Wall Street make index funds, a good investment, into a bad one? Sure.

Index funds are a low-cost way to get exposure to stocks

Their main advantage: Low cost

Don’t buy high-cost, highly specialized, or ultra-risky index funds

If you try really hard, you can make any good thing bad, and that’s exactly what Wall Street has done to some index funds. How bad? Very bad. Let’s take a look at the worst index funds.

First: Index funds really are good things. They give you a slice of a diversified portfolio of stocks at an exceptionally low price — as little as $5 per $10,000 invested, in the case of the Admiral shares of the Vanguard 500 Index fund. The average stock fund, in contrast, will charge you $120 year, according to Lipper, which tracks the funds.

How do you make a good thing bad? Three ways:

Charge a lot for it. The overriding advantage of an index fund is its low cost. It’s hard enough for a fund manager to beat the Standard & Poor’s 500 stock index. Beating the S&P 500 by more than 1.2% year after year makes Sisyphus’ job look easy.

The most expensive S&P 500 index fund: Rydex S&P 500 H shares, which charges 1.57% in annual fees. Not surprisingly, it is also the worst-performing S&P 500 index fund the past five years. While the average S&P 500 index fund turned $10,000 into $22,494 the past five years, Rydex S&P 500 H shares turned $10,000 into $21,137 — a $1,357 difference.

Specialize it. When you invest in a broad-based index, you get the volatility of the stock market. But when you invest in a specialized index, you more volatility. In general, the specialization you get, the greater the volatility. For example, the worst 12 months for the S&P 500 the past two decades has been a 44.8% loss the 12 months ended February 2009. The financial sector clocked a 70.7% loss the same period.

The more specialized you get, the greater your chance of loss. It should be no wonder, then, that one of the worst-performing funds the past five years has been an index fund: The United States Natural Gas fund, down 88.94% the past five years.

Leverage it, specialize it, and charge a lot for it. Leverage, in the financial world, means using futures and options to supercharge returns — both up and down. Direxion Financial Bear 3X shares takes an index of financial services stocks and leverages it by 300%. Unfortunately, it bets against the index, which has risen smartly the past three years. The fund has lost 99.7% of its value the past five years. Put more graphically, it has turned $10,000 into $30. The charge for that service? About 0.95% a year.

Why do bad index funds happen to good people? Sometimes, as in the case of Rydex S&P 500 H shares, it’s because they’re sold the fund by an adviser. Other times, it’s because they are lured by the prospect of huge returns. Had you invested in the PowerShares NASDAQ Internet Portfolio five years ago, for example, you would have gained 408.6%.

But your best bet is to avoid temptation and look for the lowest-cost, most broadly diversified index fund you can find for a core holding. Three suggestions:

• Vanguard Total Stock Market, which tracks the performance of the entire stock market. The investor class shares charge 0.17% a year in expenses; the Admiral shares charge just 0.05% a year. The fund has gained 57% the past three years.

• Fidelity Spartan International Index Fund, which tracks the performance of large-company foreign stocks. The fund charges just 0.27% a year in expenses, and has gained 27% the past three years.

• Vanguard Total World Stock, which invests in an index that tracks both U.S. and foreign stock performance. The fund charges 0.35% a year and has gained 33% the past three years.