Index funds: a good driver of investment returns
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Get more if you pay more?
That Yale study revealed an interesting discovery: Funds that have the highest active share percentages of stocks (those that deviate 70 percent or more from their benchmark index) had both higher expense ratios (1.57 percent on average) but also higher returns (1.39 percent higher than their benchmark index on average per year). Since performance numbers are given net of expenses, these managers had to actually outperform by nearly 3 percentage points to defeat their benchmarks -- no small feat when you consider trading costs are also involved.

Conversely, those managers whose portfolios had an active share of only 30 percent to 40 percent charged lower fees (1.13 percent on average) but lagged their benchmarks by 1.41 percentage points. The average index fund in the study had expenses of 0.55 percent.

Investors are always tinkering with the index to come up with ways to enhance it. Some fund offerings include equal-weighted indexes as opposed to those that are weighted by market capitalization. The latest idea, tendered by Jeremy Siegel, a finance professor at The Wharton School of the University of Pennsylvania, involves a "fundamentally weighted index" that takes dividends and other data into account in its assignation of weightings. Siegel is part of an ETF startup company that launched several index products in June. You can read more about it at the Wharton Web site (registration required).

And of course, exchange-traded funds are another brand of index funds that have emerged in a big way in recent years. But so far they do not have a big presence in the 401(k) market.

So, just buy an index fund then
My largest holding in the company 401(k) plan, with a 25 percent allocation, is an S&P index fund. Besides that, I have 30 percent divided among two bond funds, 35 percent among two actively managed growth and income funds, and 5 percent each in an actively run global fund and a passive small-cap fund. So I take the indexing strategy fairly seriously.

We're generally stuck with whatever we get in our 401(k) plans, but when investing in an IRA or in a taxable account, it's important to carefully select which index funds to choose because they can vary a lot.

Morningstar provides a list of funds that emulate the most popular benchmark: the S&P 500. Notice that those with the lowest fees generally have higher returns. Fees are a drag on performance, accounting for most of an index fund's tracking error -- a performance discrepancy between its returns and that of its benchmark. So when shopping for an index fund, go for the cheapest.

For instance, a $10,000 investment in Vanguard 500 Index fund, with an expense ratio of 0.18 percent, would have grown to $22,631 after 10 years. But the same investment in Wells Fargo Advantage Equity Index, with an expense ratio of 0.64 percent would have been worth $21,232 -- a $1,400 discrepancy.