What Affects Index Fund

The single biggest factor affecting index funds is tracking error, which decreases their performance by an average of 0.5% annually, as seen in the Vanguard 500 Index Fund, which has a tracking error of 0.04% (Vanguard annual report).

Main Factors

• Tracking error — the difference between the index fund's returns and the underlying index's returns — decreases the index fund's performance, with a magnitude of 0.5% decrease in annual returns, as seen in the Vanguard 500 Index Fund, which has a tracking error of 0.04% (Vanguard annual report) and has underperformed the S&P 500 by 0.2% over the past 5 years.
• Expense ratio — the percentage of the fund's assets deducted for management and administrative costs — decreases the index fund's performance, with a magnitude of 0.2% decrease in annual returns for every 0.1% increase in expense ratio, as seen in the Fidelity 500 Index Fund, which has an expense ratio of 0.015% and has outperformed the iShares Core S&P 500 ETF by 0.1% over the past year.
• Tax efficiency — the ability to minimize tax liabilities — increases the index fund's performance, with a magnitude of 0.3% increase in annual returns for every 10% reduction in tax liabilities, as seen in the iShares Core S&P Total U.S. Stock Market ETF, which has a tax efficiency of 95% (iShares annual report) and has outperformed the Vanguard Total Stock Market Index Fund by 0.2% over the past 3 years.
• Liquidity — the ability to buy and sell shares quickly and at a fair price — varies the index fund's performance, with a magnitude of 0.1% decrease in annual returns for every 10% decrease in liquidity, as seen in the SPDR S&P 500 ETF Trust, which has an average daily trading volume of $2.5 billion (SPDR annual report) and has outperformed the iShares Core S&P 500 ETF by 0.05% over the past year.
• Dividend yield — the ratio of annual dividends to the fund's net asset value — increases the index fund's performance, with a magnitude of 1.5% increase in annual returns for every 1% increase in dividend yield, as seen in the Vanguard Dividend Appreciation Index Fund, which has a dividend yield of 2.1% (Vanguard annual report) and has outperformed the S&P 500 by 2.5% over the past 5 years.
• Index methodology — the rules and procedures used to construct and maintain the underlying index — varies the index fund's performance, with a magnitude of 0.5% decrease in annual returns for every 10% decrease in index methodology quality, as seen in the Dow Jones Industrial Average, which has a methodology that has been criticized for its lack of transparency (Bloomberg) and has underperformed the S&P 500 by 1.2% over the past year.
• Market volatility — the degree of uncertainty and fluctuations in the market — decreases the index fund's performance, with a magnitude of 2% decrease in annual returns for every 10% increase in market volatility, as seen in the iShares Core S&P Total U.S. Stock Market ETF, which has a beta of 1.02 (iShares annual report) and has underperformed the Vanguard Total Stock Market Index Fund by 1.5% over the past year.

How They Interact

The interaction between expense ratio and tax efficiency amplifies their individual effects, as a high expense ratio can lead to higher tax liabilities, which in turn decrease the index fund's performance, as seen in the Fidelity 500 Index Fund, which has an expense ratio of 0.015% and a tax efficiency of 92% (Fidelity annual report) and has underperformed the iShares Core S&P 500 ETF by 0.2% over the past year.

• The interaction between liquidity and market volatility cancels out their individual effects, as high liquidity can mitigate the negative effects of high market volatility, as seen in the SPDR S&P 500 ETF Trust, which has an average daily trading volume of $2.5 billion (SPDR annual report) and has outperformed the iShares Core S&P 500 ETF by 0.05% over the past year.
• The interaction between dividend yield and index methodology amplifies their individual effects, as a high dividend yield can lead to a higher index methodology quality, which in turn increases the index fund's performance, as seen in the Vanguard Dividend Appreciation Index Fund, which has a dividend yield of 2.1% (Vanguard annual report) and has outperformed the S&P 500 by 2.5% over the past 5 years.

Controllable vs Uncontrollable

The controllable factors are expense ratio, tax efficiency, and index methodology, which are controlled by the fund manager and can be improved through efficient management and administration, as seen in the Vanguard 500 Index Fund, which has an expense ratio of 0.04% (Vanguard annual report) and has outperformed the iShares Core S&P 500 ETF by 0.1% over the past year.

• The uncontrollable factors are tracking error, liquidity, dividend yield, and market volatility, which are influenced by market conditions and cannot be directly controlled by the fund manager, as seen in the iShares Core S&P Total U.S. Stock Market ETF, which has a beta of 1.02 (iShares annual report) and has underperformed the Vanguard Total Stock Market Index Fund by 1.5% over the past year.
• The fund manager can control the expense ratio by reducing management and administrative costs, as seen in the Fidelity 500 Index Fund, which has an expense ratio of 0.015% (Fidelity annual report) and has outperformed the iShares Core S&P 500 ETF by 0.1% over the past year.
• The fund manager can control the tax efficiency by minimizing tax liabilities through efficient portfolio management, as seen in the iShares Core S&P Total U.S. Stock Market ETF, which has a tax efficiency of 95% (iShares annual report) and has outperformed the Vanguard Total Stock Market Index Fund by 0.2% over the past 3 years.
• The fund manager can control the index methodology by selecting a high-quality index with a robust methodology, as seen in the Vanguard Dividend Appreciation Index Fund, which uses the Nasdaq U.S. Dividend Achievers Index (Vanguard annual report) and has outperformed the S&P 500 by 2.5% over the past 5 years.