Volatility has returned to the market in a big way. Just follow the Dow Jones Industrial Average, which has managed to rise or fall hundreds of points from session to session. Happily, as Vanguard founder Jack Bogle reminds us, investors in the best index funds can sleep well and totally ignore all this chaos.
Bogle is the original proponent of the index fund — a low-cost mutual fund or exchange-traded fund that passively seeks to replicate the returns of some benchmark index — and as boring as his message gets, he really is more right than wrong for the bulk of investors.
Indeed, the great majority of investors would do themselves a favor by buying only index funds. After all, it’s almost impossible to beat the market consistently over long periods of time. Even Warren Buffett — a long-time market beater — comes up short some time.
Even worse, something like 80% of actively managed — and therefore more expensive — funds fail to outperform their benchmarks in any given period. Generally speaking, the longer the time frame, the higher the rate of underperformance.
That’s what makes index funds so appealing. Hey, if you can’t beat the market, then join it. True, you can never beat the market with index funds — you’ll actually lag a tiny bit after expenses — but neither will you pay a fund manager for underperformance. (Index funds are cheap because they’re essentially automated.)
Most investors would do well with a portfolio of four to seven index funds, preferably ETFs, because they’re liquid and offer the lowest fees. From stocks to bonds to emerging markets to rich-world blue-chip stocks, these are the seven best ETFs to build a comprehensive and balanced portfolio.
Best Index Funds — Vanguard S&P 500 ETF (VOO)
Index: S&P 500 (U.S. large-cap index)
There are a number of mutual funds and ETFs that track the S&P 500 — the benchmark for U.S. equity performance — but you can’t get cheaper than the Vanguard S&P 500 ETF (VOO).
The S&P 500 is a great foundation on which to build your passive portfolio. After all, the U.S. stock market is the largest and most liquid pool of equities on the planet. Furthermore, over long periods of time, the S&P 500 has been a return machine, generating about 7% a year after inflation. At that rate you will double your money every 10 years.
Heck, even Warren Buffett says 90% of a retirement portfolio should sit in an S&P 500 index fund — preferably Vanguard’s.
Best Index Funds — Vanguard FTSE Developed Markets ETF (VEA)
Index: FTSE Developed ex North America Index (Global, developed-market index)
Once you have your foundation set with the S&P 500, it’s time to start diversifying your holdings. This will help you maximize your risk-adjusted returns. The first place you want to go for diversification are big international stocks in developed (essentially wealthy) nations.
The best ETF to capture overseas growth in the rich world is the Vanguard FTSE Developed Markets ETF (VEA) — once again because it can’t be beaten on price.
European stocks account for about 60% of the portfolio, with Asian and Australian stocks making up most of the balance. In another big plus, European stocks tend to pay much bigger dividends than their U.S. counterparts, so the trailing 12-month yield on VEA is pretty sweet at 3.46%.
Best Index Funds — MSCI Vanguard FTSE Emerging Markets ETF (VWO)
Index: FTSE Emerging Index (Global, emerging-market index)
Now that we’ve got the U.S. and developed world covered, it’s time to add a little risk in order to participate in greater gains. The developing world consists of nations with high-growth, diversified economies and rapidly rising living standards (that is, a burgeoning middle class.)
Because they are working off such a low base, developing economies can grow much faster than their counterparts in the developed world. Just look at China. Investors are wringing their hands over its economic slowdown, but it’s still growing at 7% per year.
The MSCI Vanguard FTSE Emerging Markets ETF (VWO) is the best way to capture growth in China and other emerging markets. True, the iShares MSCI Emerging Markets (EEM) is far more liquid, but it’s expensive and sports a lower yield.
Best Index Funds — Vanguard Total Bond Market ETF (BND)
Index: Barclays U.S. Aggregate Float Adjusted Bond Index (Broad U.S. bond index)
A (very) general rule of thumb is to allocate 60% of your portfolio to stocks and 40% to bonds. Other folks say you should subtract your age from 100. That number is the percentage of your money that should be invested in stocks, with the rest going to bonds. Either way, fixed income is a must for a balanced portfolio.
Bonds are inversely correlated with stocks. When stocks go down, bonds tend to go up. That will give your portfolio ballast in bear markets or any other time the market sells off (or crashes.)
The Vanguard Total Bond Market ETF (BND) is the best bond fund for those purposes. It tracks the benchmark index of U.S. bond market performance and offers one-stop shopping for everything from U.S. Treasury debt to mortgage-backed securities. It only holds investment-grade securities, so the yield isn’t very exciting (2.55% over the trailing 12 months), but it’s great for keeping things balanced.
Best Index Funds — Vanguard High Dividend Yield ETF (VYM)
Index: FTSE High Dividend Yield Index (U.S. large-cap value index)
Okay. So you have your bases covered with stocks and bonds. At this point any ETFs you add are really more for your personal goals and risk tolerance.
If you’re young or more of a gambler, you could add a frontier markets ETF like the iShares MSCI Frontier 100 Index Fund (FM). On the other hand, if all you care about is capital preservation, you can’t go wrong with the iShares TIPS Bond ETF (TIP).
For a more balanced approach there’s nothing quite like Vanguard High Dividend Yield ETF (VYM). High-yield dividend stocks have good potential for price appreciation. At the same time, they add income to the income part of your portfolio. Most importantly, they’re not at risk when interest rates go up. “High yield,” however is a relative term, as VYM has a yield of 2.76% over the trailing 12 months.
Best Index Funds — iShares Russell 2000 (IWM)
Index: Russell 2000 small-cap index
Like emerging markets, small-cap stocks have greater potential for price appreciation because they’re growing off a smaller base. Additionally, small-cap stocks get less attention from analysts and the financial press, so they’re more likely to be mispriced.
The Russell 2000 is the benchmark index for small-cap performance, which makes the iShares Russell 2000 ETF (IWM) an ideal way to participate in any small-cap gains.
Small-cap stocks are riskier than their bigger brothers. They tend to be more sensitive to economic and market developments as they plug most of their cash back into growing their businesses. They also have a harder time borrowing money and pay higher rates for it. That’s why IWM is a peripheral and not a core ETF.
Best Index Funds — SPDR Barclays High Yield Bond ETF (JNK)
Index: Barclays High Yield Very Liquid Index
Now that you’ve added some spice to the equity part of your portfolio, it’s time to juice the yield stream from the fixed income side of things. A good way to do just that is the SPDR Barclays High Yield Bond ETF (JNK).
Junk bonds have a greater risk of default than investment-grade debt, which is why they offer higher yields. (An entire fund of junk bonds isn’t going to default at once, so don’t worry.) Rising interest rates are a big concern for all types of bonds, which is why JNK should be a strategic long-term holding.
With a trailing 12-month yield of 5.89%, JNK throws off a heavy amount of income, which will go a long way toward making up for interest rates that are still near all-time lows.
As of this writing, Dan Burrows did not hold a position in any of the aforementioned securities.