The truth about index funds (2023)

Index funds designed to track the highs and lows of a specific index, from the S&P 500 Index to the Barclays Capital California Municipal Bond Index, have become extremely successful. Index investing was introduced to the public in the 1970s with mutual funds. The strategy received a major boost in the 1990s with the advent of exchange-traded funds (ETFs), which can be bought and sold like stocks.

However, index funds only really attracted attention around the turn of the millennium. Between 2010 and 2020, they grew from 19% of the total fund market to 40%, and two years ago the total assets invested in US stock index funds surpassed the assets in actively managed funds. The 13 largest equity funds track all indices.

No wonder: Compared to managed funds, index funds offer better average returns, mainly because their costs are lower. According to the Morningstar Fund Tracker, the 10-year return is aroundVanguard S&P 500(FLIGHT(opens in a new tab)), a very popular benchmark-linked ETF with an expense ratio of just 0.03%, outperformed 87% of its 809 peers in the large-cap mix category. The Index has outperformed most of these peers in each of the last 10 calendar years.

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Pros and Cons: Index Funds vs. Stocks – SmartAsset

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Also, because few of their constituents change each year (the Vanguard fund's annual turnover rate is only 4%), index funds are subject to minimal capital gains tax obligations. (Returns and other data are as of August 6; index funds I recommend are in bold.)

Specialized index funds: ETF such as iShares MSCI Brasil (EWZ(opens in a new tab)) or the TIAA-CREF Small Cap Mix Index (TRHBX(opens in a new tab)) - are simple. They allow you to own a country, region, investment style or industry without having to select individual stocks or bonds. But what if you want to dominate the market in whole or in part? The options can be overwhelming and not necessarily what they seem.

Start with the S&P 500, which consists of the approximately 500 largest US companies by market capitalization (number of shares outstanding multiplied by price). Like most indices, the S&P 500 is cap-weighted: the larger a company's market cap, the greater its impact on index performance. Garbage (AAPL(opens in a new tab)) for example about 60 times stronger than General Mills (SAY(opens in a new tab)).

Any index fund with a limited weighting is a great bet on the larger companies. Lately this bet has becomeextremelydifficult because some actions became gigantic. For example, in 2011, the combined market value of the 10 largest stocks in the S&P 500 was $2.4 trillion. It's currently $13.7 trillion. Apple itself now has a cap as big as the top 10 S&P stocks combined a decade ago.

Or just consider the fivetrillion sharesI recently highlighted. Simple, Alphabet (Google(opens in a new tab)), Amazon.com (AMZN(opens in a new tab)), Apple, Facebook (Facebook(opens in a new tab)) and Microsoft (MSFT(opens in a new tab)) make up 22% of the value of the S&P 500. In recent years, these stocks have been on the rise, and the index has benefited.

directed bet

You may think that you get broad diversification when you buy, but you're actually making a substantial bet on a handful of stocks in the same industry. On July 31, information technology, Apple category andcommunication services, the Facebook sector, and Google parent Alphabet make up a staggering 39% of the S&P 500.Energyaccounts for only 2.6%.

Most of the other popular broad indices are just as heavy and focused onTechnology. Consider the MSCI US Broad Market Index and other metrics that measure all or most of the roughly 4,000 stocks traded on US exchanges.

The $5 trillion in stock accounts for about 18% of the company's assets.Avant-garde overall exchange(IF P(opens in a new tab)), the most popular of the ETFs based on these indices; that's just a few percentage points less than the weight of the trillionaires in the S&P 500.iShares Russell 1000(PDI(opens in a new tab)) is an ETF whose portfolio is based on an index of the 1,000 largest stocks. He has about 20% of his wealth in the trillionaires; 36% in technology and communications.

I still like trillionaires and I like technology, but I've chosen not to delude myself that most index funds that track the S&P 500 are the best way to dominate the US market.

Most consultants, myself included, recommend a balanced approach. For example, I have a personal plan to put the same amount of money into each of the dozens of diversified stocks I own each month. So at the end of each year I rebalance by buying and selling so that each stock is worth the same amount. This strategy also makes sense for broad market investing, but most popular index funds don't offer it.

While technology is hot right now, industry weightings change over time. Don't want your portfolio to focus on sectors and stocks that aren't popular?

Between 2014 and 2020, technology ranked in the top four of 11 sectors in all but one year and in first place in three years. On the other hand, energy has been bottom for five of the last seven years, andconsumer stockswie Procter & Gamble (PG(opens in a new tab)) ranked in the bottom half of the industry rankings for five consecutive years. If you buy the S&P 500, you get a lot of technology but little in energy and consumer goods, which is the opposite of what bargain hunters want.

The balanced solution

However, there are ways to avoid carrying some stocks or sectors.

One of them is the S&P 500 Equal Weight Index. Each stock represents about 0.2% of total assets (there are actually 505 stocks in the S&P 500 Index), with a rebalance at the end of each quarter. As a result, each time the index rebalances, the trillionaires account for about 1% of equity; Technology and Communications, 20%. Over the past 10 years, the S&P 500 has outperformed its equally weighted cousin by about a percentage point on an annualized basis, but that's not unexpected in what has been a great decade for high-growth stocks.

Invesco S&P 500 equivalent weight(RRP(opens in a new tab)), a 0.2% expense index ETF, offers an easy way to buy the index. Keep in mind that its trading volume at 24% is much higher than the trading volume of a standard broad market index fund; As such, it's best to keep it in a tax-advantaged account like an IRA.

A second index alternative is my old favorite, the Dow Jones Industrial Average, which consists of just 30 large-cap stocks. The Dow is weighted by price. In other words, the higher a stock's share price, the greater the company's impact on the value of the index.

Oddly enough, price weighting increases portfolio diversification, as rising stocks tend to split quickly and new companies take their place at the top of the index. (Many big tech companies in particular rarely split their stocks. But the Dow Jones doesn't let them in because of that.)

You can buy the Dow through theSPDR Promedio Industrial Dow Jones ETF(LEAVES(opens in a new tab)), nicknamed Diamonds, with an expense ratio of 0.16%. The fund's 10-year average annual return is nearly two points below the S&P 500, but that's not bad considering technology and communications make up just 22% of the portfolio.

I'm not telling you to avoid traditional broad market funds. Please note that I still recommend them. I'm just saying that there are other ways to get better diversification and get closer to actually owning the US stock market.