Best index funds for 2020 (Even After Covid19)
Financial planners and legendary investor Warren Buffet both agree. Index funds are one of the best investments for building long-term wealth. Buffett has praised index funds on multiple occasions, once calling the index fund “the most sensible equity investment.” Index funds may sound intimidating, but they’re really just a type of mutual fund. Nevertheless, they are an all-in-one investment that diversifies your money across a broad selection of stocks or bonds. Rather than choosing and buying individual stocks, an investor owns a small piece of every company or asset in the index fund. This minimizes overall risk. Best of all, index funds are low-cost and regularly outperform actively managed funds, year after year.
Best Index Funds – Why Index Funds?
So, if Warren Buffett says you should be investing in Index Funds, you should probably at least take a look, right?. But, how does one get involved in index funds. To answer that, let’s start with the basics.
What is an Index Fund?
You already know what a stock market index is. For example, two of the most popular stock market indices are the S&P 500 and the Dow Jones Industrial Average. Each index is made up of a collection of stocks, and the value of this group of stocks is reflected by a number that represents the market capitalization weighted average.
The Standard & Poor’s 500 tracks the 500 largest (measured by market value) publicly traded companies. The publishing firm Standard & Poor’s created this index. Because it contains 500 companies, the S&P 500 represents overall market performance better than the Dow Jones Industrial Average’s (DJIA) 30 companies. Money managers and financial advisors actually watch the S&P 500 stock index more closely than the DJIA.
An index fund is a specific type of mutual fund, where money is pooled by investors. It is deliberately constructed to match the performance of a specific market index. For example, the Vanguard 500 Index Fund approximates the make-up of the S&P 500. Index funds can also be constructed to track particular sectors like commodities or utilities. Most large-cap mutual funds like to measure their performance against the S&P 500 rather than against any other index. Mutual funds that concentrate on small-cap stocks usually prefer an index that has more small-cap stocks in it, such as the Russell 2000.
Why are Index Funds Considered Passive?
As explaind above, an index fund is a pool of investment money that is based on a preset basket of stocks, or index. An index fund can either a mutual fund or an exchange-traded fund (ETF). The fund itself may be created by the fund manager, or by another company such as an investment bank or a brokerage. These fund managers copy the index. They create a fund that looks as much as possible like the actual index. Because it is a copy of an existing index, there is no effort required to actively manage the fund.
Over time the index may change, as companies are added and deleted. The fund manager then mechanically replicates those changes in the fund. So, the fund manager is basically a clerk. His job is to do nothing more than copy the index as closely as possible. He has no responsibility to choose stocks other than those that comprise the index.
Because of this approach, index funds are considered passive investing. This is much different than active investing where a manager analyzes stocks and tries to pick the best performers. A passive approach means that index funds tend to have low expense ratios, keeping them cheap for investors getting into the market.
Why are Index Funds so Popular?
Investors like index funds because they offer immediate diversification. With one purchase, investors can own a wide aggregate of companies. For example, one share of an index fund based on the S&P 500 provides ownership in hundreds of companies. While some funds such as S&P 500 index funds allow you to own companies across industries, others allow exposure to a specific industry, country or even investing style, like dividend stocks.
However, an index fund based on the S&P 500 continues to be among the most popular. Historically, S&P 500 funds offer a good return over time. Also, they’re diversified which spreads risk over 500 different companies. That’s about as low risk as stock investing gets. Of course, it will fluctuate. But over time the index has returned about 10 percent annually. That doesn’t guarantee index funds make money every year. Nevertheless, over long periods of time that’s been the average return.
Index funds are different from traditional mutual funds in that they are not actively managed. There’s no fund manager calling the shots behind the scenes. There’s no one selecting stocks or changing the makeup of the portfolio. The index you buy is exactly what you get. Instead of a fund manager, there is likely a computer that tracks the market and rebalances the fund as required. This is so that it matches the market index it is following as closely as possible. By investing in an index fund, you live and die by the market index you track.
Why should I Invest in an Index Fund?
Most people believe that the job of a fund manager is to beat the market. Does it make sense to buy into a fund that just copies an index, or the market as a whole? Actually, it does. And the Oracle of Omaha, Warren Buffett tends to agree.
Benefits of Index Funds
Outperformance
Investors will generally be able to beat actively managed funds in the long run by investing in index funds. Warren Buffett himself requested that this estate be put into index funds.
“Put 10% of the cash in short-term government bonds and 90% in a very low-cost S&P 500 index fund. (I suggest Vanguard’s.) I believe the trust’s long-term results from this policy will be superior to those attained by most investors – whether pension funds, institutions or individuals – who employ high-fee managers.” – WB
Studies have shown that the majority of actively managed mutual funds fail to beat the overall market in the long run. In the short run, some may do better than others, but time does not paint a good picture. One study followed the performance of 2,076 actively managed mutual funds from 1976 to 2006. After fees, they found that 75% of the funds failed to generate a return greater than the overall market. By investing in an index fund, you’re already doing better than 75% of the mutual funds out there.
Low Fees & Passive Investment
Index funds don’t require much management as they are passive investments. Just set it and forget it. These types of investments also allow investors to invest in a large segment of the market – easily diversifying one’s portfolio. Additionally, index funds don’t have a lot of costs associated with them like mutual funds. There are no sales commissions, and because they are run by computers, the operating costs are way lower.
Diversify your investment
An index fund is already a diversified investment. You could invest all your money in the Vanguard 500 and be done with it. But, why put all your eggs in one diversified basket? Most financial experts will tell you to have some sort of allocation between stocks and bonds. That makes a lot of sense, but can you do that with a fund?
Two Fund Portfolio – One for Stocks, One for Bonds
One strategy is to go with the two-fund portfolio. Two Vanguard funds that fit the above profile would be the Total Bond Market Index Fund, which holds U.S. Treasuries, home mortgage securities and high-quality corporate bonds. At the same time, you could also own the Total World Stock Index Fund. This gives you access to stocks from around the globe. Both funds comprise thousands of securities – meaning you’re safely diversified.
Or, One for Domestic Stocks, one for International, and one for bonds. Another strategy is to have international and domestic exposure in the same portfolio, as well as equity and bond exposure. This allows you to absorb swings in the global stock market. Split your portfolio equally between the Vanguard 500, which mimics the S&P 500. Include the Vanguard Total International Stock Index Fund, which gives you exposure to both developed and emerging international economies. Finally, add the Vanguard Total Bond Market Index Fund. This way you’ve got a bit of everything. Once a year, rebalance your portfolios so that there are equal amounts in each of the three index funds you’re good to go.
Life Cycle Index Fund
If you are incredibly lazy, you could even invest in a life cycle index fund. Most finance experts recommend an allocation between stocks and bonds, an allocation that should shift more towards bonds as time goes on and retirement draws closer. Rebalancing between equity and bonds like that can be time-consuming, unless you own a lifecycle fund. Also known as target-date funds, these investments rebalance themselves over time – shifting to more conservative assets as you age. By the time you are ready to retire, your portfolio will have gone from 90% stocks, 10% bonds to 90% bonds and 10% stocks.
Vanguard – Their Best Index Funds
As noted above, Vanguard has more than 100 index funds and ETFs from which to choose. Which fund is best for you depends on your portfolio mix and what you can afford based on account minimum and fees. You can also check the fund’s historical performance — with the standard caveat that past performance does not guarantee future results. Some popular Vanguard index funds include:
1 Vanguard 500 Index Fund
Also known as the Vanguard S&P 500 Index fund, this is the one that started them all, giving investors exposure to 500 of the largest U.S. companies, which make up 75% of the U.S. stock market’s total value.
Minimum investment: $3,000. Expense ratio: 0.04%.
2 Vanguard Total Stock Market Index Fund
Three-quarters of the U.S. stock market not enough? This fund covers the entire U.S. equity market, including small-, mid- and large-cap growth and value stocks.
Minimum investment: $3,000. Expense ratio: 0.14%.
3 Vanguard Total Bond Market Index Fund
This fund gives wide exposure to U.S. investment-grade bonds, investing about 30% in corporate bonds and 70% in U.S. government bonds.
Minimum investment: $3,000. Expense ratio: 0.15%.
4 Vanguard Balanced Index Fund
As the name suggests, this fund mixes its investments between stocks (roughly 60%) and bonds (about 40%) to balance growth through exposure to equities with stability through fixed-income investments.
Minimum investment: $3,000. Expense ratio: 0.19%.
5 Vanguard Growth Index Fund
This fund has a buy-and-hold approach for stocks in large U.S. companies in sectors that have larger growth potential, such as technology, consumer services and financial services.
Minimum investment: $3,000. Expense ratio: 0.17%.
6 Vanguard Small Cap Index Fund
Big companies aren’t the only potentially profitable players in the stock market. This fund targets smaller publicly held companies, for investors who want to diversify investments away from larger public companies.
Minimum investment: $3,000. Expense ratio: 0.17%.
7 Vanguard Total International Stock Index Fund
Total U.S. market not enough? This fund takes on the world, tracking stock indexes in both developed and emerging markets across the globe.
Minimum investment: $3,000. Expense ratio: 0.17%.
8 Vanguard Total International Bond Index Fund
This fund tracks the performance of non-U.S. investment-grade bonds from corporations and governments in developed and emerging markets.
Minimum investment: $3,000. Expense ratio: 0.13%.
Best index funds (If you don’t want Vanguard)
The list below includes S&P 500 index funds from a variety of companies, and it includes some of the lowest-cost funds trading on the public markets. When it comes to an index fund like this, one of the most important factors in your total return is cost. Included are two mutual funds and two ETFs:
- Fidelity ZERO Large Cap Index
- SPDR S&P 500 ETF Trust
- iShares Core S&P 500 ETF
- Schwab S&P 500 Index Fund
9. Fidelity ZERO Large Cap Index (FNILX)
The Fidelity ZERO Large Cap Index mutual fund is part of the investment company’s foray into mutual funds with no expense ratio, thus its ZERO moniker. The fund doesn’t officially track the S&P 500 – technically it follows the Fidelity U.S. Large Cap Index – but the difference is academic. The real difference is that Fidelity doesn’t have to cough up a licensing fee to use the S&P name, keeping costs lower for investors.
Expense ratio: 0 percent. That means every $10,000 invested would cost $0 annually.
10. SPDR S&P 500 ETF Trust (SPY)
The SPDR S&P 500 ETF is the granddaddy of ETFs, having been founded all the way back in 1993. It helped kick off the wave of ETF investing that has become so popular today. As of Dec. 2019, it had $302 billion in assets, ranking it among the most popular ETFs. The fund is sponsored by State Street Global Advisors — another heavyweight in the industry — and it tracks the S&P 500.
Expense ratio: 0.09 percent. That means every $10,000 invested would cost $9 annually.
11. iShares Core S&P 500 ETF (IVV)
The iShares Core S&P 500 ETF is a fund sponsored by one of the largest fund companies, BlackRock. With nearly $200 billion in assets (as of Dec. 2019), this iShares fund is one of the largest ETFs and like other large funds, it tracks the S&P 500. With an inception date of 2000, this fund is another long-tenured player.
Expense ratio: 0.04 percent. That means every $10,000 invested would cost $4 annually.
12. Schwab S&P 500 Index Fund (SWPPX)
With nearly $43 billion in assets (as of Dec. 2019), the Schwab S&P 500 Index Fund is on the smaller side of the heavyweights on this list, but that’s not really a concern for investors. This mutual fund has a strong record dating back to 1997, and it’s sponsored by Charles Schwab, one of the most respected names in the industry. Schwab is especially noted for its focus on making investor-friendly products, as evidenced by this fund’s razor-thin expense ratio.
Expense ratio: 0.02 percent. That means every $10,000 invested would cost $2 annually.
Best Index Funds – Frequently Asked Questions
Best Index Funds – Bottom line
These are some of the best S&P 500 index funds on the market. They offer investors a way to own the stocks of the S&P 500 at low cost. Further, they offer the benefits of diversification and lower risk. With those benefits, it’s no surprise that these are some of the largest funds on the market. Even Warren Buffett thinks so!
