Have you ever been to a restaurant where every item looked delicious and wished you could simply order the entire menu? Your stomach (and wallet) would likely limit your progress, but sometimes, choosing one item from an appealing list is difficult. Investors used to have a similar problem: with so many great companies in the market, how do you choose? However, unlike restaurant-goers, investors can buy the whole market through assets like indexed mutual funds.
What Is an Index Fund?
Index funds are a relatively new innovation in the investment world. The idea had been bouncing around academia since the 1960s, but it wasn’t until Vanguard founder John Bogle developed the Vanguard Index Trust in 1975 that index funds became available to everyday investors. Bogle’s idea was simple: if most mutual fund managers couldn’t beat the S&P 500, why not just cut them out and buy the entire stock index?
Bogle’s fund didn’t attempt to beat market averages or produce outsized gains. Instead, he devised a system of rules so the fund would emulate the performance of the S&P 500, adjusting its holdings following the weights of the underlying stocks. By removing the managerial role, Bogle’s fund reduced overhead costs, and investors got more bang for their buck through reduced expenses.
Why Are Index Funds a Popular Investment?
If index funds are designed to limit returns to market averages, why are they so popular? Because for many investors, the market average is preferred to the uncertainty (and cost) of employing an active stock-picking manager.
For example, if you’re saving for retirement, you might not want to switch funds constantly chasing the hottest stock picker. Even the best managers, like Benjamin Graham and Peter Lynch, eventually ran out of special sauce. And that’s if you were sharp enough to identify them early on in their careers when they still had years of outperformance ahead of them.
For many investors, choosing low fees and broad diversification makes more sense than chasing performance and paying high costs for the top fund managers, especially when past performance does not guarantee future results. In fact, since the advent of the index fund, the number of managers who can consistently beat market averages over extended time frames is a select group. Studies have shown that over 66% of active managers underperform market benchmarks in a year. Not only that, but due to their elevated costs, active managers can’t just settle for a few extra basis points of returns -- a manager charging a 1% fee must beat the S&P 500 by at least 0.97% to match the same return as some of the index funds listed below.
S&P 500 Index Funds
The S&P 500 often doubles as a proxy for the U.S. stock market. It comprises the top 500 publicly traded American companies, determined by a rules-based system and chosen by a committee. The index is rebalanced every quarter, and the list of funds that use the S&P 500 as a proxy is vast.
For S&P 500 consideration, a company must be headquartered in the United States and have a market cap of at least $18 billion. It must also have four consecutive quarters of positive earnings (including the most recent quarter) and trade 250,000 shares monthly for at least six months. Many of the assets that make up retirement accounts, institutional portfolios, and public funds are S&P 500 stocks. Specific securities like American depositary receipts (ADRs), exchange-traded funds (ETFs) and closed-end funds are not eligible for inclusion.
Here are three index mutual funds that track the S&P 500 index and why you should consider them for your portfolio.
Vanguard 500 Index Fund
Sometimes, the old ways are still the best, and the Vanguard 500 Index Fund (VFIAX) imitates Jack Bogle’s first index mutual fund from the 1970s. With over $1 trillion in assets, VFIAX has been trading in its current incarnation since 2010 and carries a modest 0.04% expense rate. Over the last five years, the fund has returned an average of 15% annually, higher than the S&P 500’s 13.3% average annual return in the same time frame.
Schwab S&P 500 Index Fund
Charles Schwab also has an affordable mutual fund to track the S&P 500’s performance. And while Vanguard is often considered the king of low-cost, Schwab has one-upped them in this department. The Schwab S&P 500 Index Fund (SWPPX) has just under $1 trillion in assets and boasts an expensive rate of just 0.02%. That’s right, only two basis points per year to invest in the 500 largest American stocks. SWPPX has slightly underperformed VFIAX in the last five years but only costs half as much as Vanguard’s flagship fund.
Fidelity 500 Index Fund
How low can you go in the war on fees? How about one basis point? That’s all Fidelity charges for their S&P 500 indexed mutual fund, which has compiled just under $600 billion in assets since its 2011 inception. By charging only 0.01% in expenses, the Fidelity 500 Index Fund (FXAIX) has brought the cost of investing closer to zero than any other peer, and you’ll still own all 500 stocks in the benchmark index.
NASDAQ Index Funds
The NASDAQ is another diverse U.S. stock index. It is both an index and an exchange, with thousands of large and small companies. Companies trading on the NASDAQ exchange are listed in the NASDAQ Composite, which can be further broken down into smaller indices like the NASDAQ 100.
The NASDAQ has more turnover than the S&P 500, and as a result, index funds using NASDAQ for an underlying tend to be more expensive than S&P 500 funds. NASDAQ stocks tend to lean toward the tech sector, with many of the highest-profile tech companies representing the most significant holdings in these funds. Additionally, since the NASDAQ is larger and more diverse, it is often considered riskier since it contains many startups and small-caps in volatile sectors.
Here are three of the top index mutual funds based on NASDAQ companies and why you should consider them for your portfolio.
Fidelity NASDAQ Composite Index Fund
The Fidelity NASDAQ Composite Index Fund (FNCMX) aims to replicate the performance of the NASDAQ Composite Index, which includes over 3,000 stocks listed on the NASDAQ exchange. This broad exposure encompasses large-cap, mid-cap, and small-cap stocks, offering a comprehensive view of the NASDAQ market. With an expense ratio of 0.29%, FNCMX provides a cost-effective way to invest in a diverse array of companies, many of which are leaders in technology and innovation. The fund's extensive holdings make it a robust option for investors seeking to capture the growth potential of the entire NASDAQ market.
Shelton NASDAQ-100 Index Direct
The Shelton NASDAQ-100 Index Direct (NASDX) provides investors with exposure to the NASDAQ-100 Index, which consists of the 100 largest non-financial companies listed on the NASDAQ. With just under $2 billion in assets and an expense ratio of 0.52%, NASDX offers a way to invest directly in some of the most significant tech and innovative companies. This fund is particularly attractive for those looking to capitalize on the growth potential of leading NASDAQ companies.
Victory Nasdaq 100 Index Fund
Like NASDX, The Victory Nasdaq 100 Index Fund (USNQX) tracks the NASDAQ-100 Index. With an expense ratio of 0.45%, USNQX offers investors a relatively low-cost means to gain exposure to some of the most influential and innovative companies in the market, particularly in the technology sector. The fund's concentrated focus on large-cap growth stocks makes it an attractive choice for those looking to benefit from the performance of major NASDAQ-listed tech giants.
How To Choose The Best Index Fund For You
How do you pick the best index funds for your portfolio? You might not like the answer, but it's a common refrain in investing: it depends. For many investors, keeping costs down will be the overarching goal. If you only care about matching market returns over time, paying four basis points for Vanguard’s S&P 500 index fund doesn't make sense when Fidelity charges one basis point for basically the same thing.
When purchasing index funds, consider your goals, risk tolerance, and time frame. Can you stomach the volatility of the tech-heavy NASDAQ, or would you prefer the more balanced S&P 500? How much money under management makes you feel comfortable, $200 billion or $1 trillion?
And don’t just consider today’s investment mindset but also what you’ll be looking for years or decades into the future. Would you regret missing out on higher-performing assets by choosing only the lowest-cost funds? Do tax implications make ETFs a better fit, or are you saving in a 401(k) account where only mutual funds are allowed? Even when picking a simple investment strategy like indexing, there is a lot to take into consideration.
Focus on Your Investment Goals and Time Horizon
Not even John Bogle could have imagined the impact index funds would have on the market when he launched the first nearly 50 years ago. While stocks had been trading for centuries, few investors chased fees over performance. However, the data hasn’t been kind to most active managers, and simplicity is a great way to avoid getting overly stressed about market performance.
But remember, index funds aren’t impervious to drawdowns, and the S&P and NASDAQ have had plenty of negative years. Indexing isn’t a cheat code for long-term wealth, and investors should still consider consulting an advisor before building a DIY index fund portfolio.
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