Index funds are one of the market’s greatest gifts for the “little guy.” Once upon a time, you’d have two options: Eat a host of trading fees while trying to amass the number of stocks it would take to create a diversified, bulletproof portfolio, or pay the heads of an actively managed fund exorbitant expenses to do the work for you.
Now, you and I can put together most of what we need — and for cheap! — by just investing in some of the best index funds Wall Street has to offer. Stocks, bonds, commodities … we can invest in just about anything for less than a penny on the dollar. And because you’ve essentially got a computer program running the show, you rack up significant savings on the expenses that typically would go to a team of fund managers and other personnel.
It’s important to note that a portfolio featuring nothing but the best index funds out there wouldn’t be a complete portfolio. For one, it’s difficult to fill out the aggressive, high-return part of one’s portfolio with diversified funds that by their very nature hold back performance. And active management has its place too — for instance, a fund manager who can shift more quickly than an index fund can make country-specific funds can shine, adjusting strategy as important local events unfold.
Still, plenty of evidence shows index funds broadly beat out their actively managed brethren — even backing out what you save in fees. If nothing else, it’s a good argument to be somewhat invested index funds … even if you don’t go so far as investing index-only.
So whether you’re making a resolution to start investing in the new year, or you’re just looking to diversify your current portfolio, read on as we look at some of the best index funds out there. These are funds that have a place on just about any investor’s roster, whether you’re buying in 2015 or later down the road.
The Best Index Funds to Buy: Vanguard S&P 500 ETF (VOO)
Type: U.S. Large-Cap Stocks
The figure typically thrown around is that 90% of active managers can’t beat the S&P 500 Index. Well, while that exact figure doesn’t necessarily hold water, the index still outperforms a majority of active managers.
Besides, you can do a lot worse for yourself than investing in 500 of Wall Street’s biggest and most established stocks. Including dividends, the S&P 500 boasts an annualized gain of 9.8% over the past 20 years. Meanwhile, you have the security in knowing that no one stock can tank the whole index — even if largest component Apple Inc (AAPL) went bankrupt tomorrow, it only represents about 3.6% of the whole index, so while the S&P 500 would hurt that day, your whole nest egg wouldn’t go kaput.
Sure, the whole market could crash as it did in 2008-09, and if — for whatever reason — you needed to liquidate your retirement holdings right then and there, you’d suffer one heck of a loss. But if you believe in the continued ability of the U.S. stock market to rebound over time (and once again, it has, to all-time highs), you should be invested in the S&P 500.
That logic makes the Vanguard S&P 500 ETF (VOO) one of the best index funds to buy, but it’s worth pointing out that you can’t really go wrong with other S&P 500-tracking funds, namely the SPDR S&P 500 ETF Trust (SPY) and the iShares Core S&P 500 ETF (IVV). All three hold the same grouping of stocks — Apple, Microsoft Corporation (MSFT), Exxon Mobil Corporation (XOM) and the like — with virtually identical weightings. The only difference? VOO is slightly cheaper than the other two, at 0.05% in expenses, or $5 for every $10,000 invested annually (the IVV charges 0.07%, and the SPY charges 0.09%).
If you believe that pricing is one of index funds’ greatest strengths, and if you can get the same holdings in VOO as you can in the SPY and IVV … well, I say squeeze as much value out of the S&P 500 as you can and buy the VOO ETF.
The Best Index Funds to Buy: iShares Core S&P Small-Cap ETF (IJR)
Type: U.S. Small-Cap Stocks
So you’ve got your domestic large caps, which provide stability, some dividends and OK growth. But you’ll also want more-than-OK growth, and that’s where small-cap stocks come in.
Small caps are inherently riskier than their larger counterparts, as the cash these companies generate typically goes right back into their operations, and their small size makes it difficult to secure debt in the hunt for growth.
On the flip side, you’re often dealing with companies that have a particularly game-changing product or service and are already growing at a rapid rate. Just think about the math — it’s a lot easier to double your revenues when you’re bringing in $1 million per year than when you’re bringing in $1 billion. And there’s nothing Wall Street loves more than a growth story, so when up-and-coming small caps show signs of progress, investors often will bid them up to sky-high premiums.
One of the best index funds you can buy to get exposure to this high-growth space is the iShares Core S&P Small Cap ETF (IJR). This ETF holds some 600 small-cap stocks that features growth stories such as Maximus, Inc. (MMS), a business support services firm that helps various governments’ health and human services programs. Maximus has grown revenues by almost 30% in each of the past two years, and its stock has returned 40% and 20% in 2013 and 2014, respectively. Or there’s Jack in the Box Inc. (JACK), whose stock has shot up 170% in the past two years as the company has rapidly improved its profits.
I prefer the IJR over the iShares Russell 2000 Index (ETF) (IWM), which tracks the most popular small-cap index, the Russell 2000. IJR has a better, more consistent performance over time and has slightly cheaper expense fees.
The Best Index Funds to Buy: iShares U.S. Preferred Stock ETF (PFF)
Type: U.S. Preferred Stocks
The last of the three best index funds involving U.S. stocks features a horse of a different color: preferred stocks.
Preferred stocks don’t get a lot of press because they’re boring as all let-out and move like a snail in molasses, but they absolutely belong in any diversified portfolio. That’s because they offer stable income, and very substantial income, at that.
These equities typically are referred to as “hybrids” because they have both bond-like traits and stock-like traits. For instance, you can buy preferred stock on an exchange, and it actually does represent equity in a company — just like common stock. However, preferred stock also resembles bonds in that it typically doesn’t have voting rights, and it throws off a fixed amount of income.
Oh, the income!
The largest preferred-stock ETF out there, the iShares U.S. Preferred Stock ETF (PFF), holds more than 300 preferred shares to provide a yield of nearly 7% currently. And because most preferred shares tend to come from the financial, real estate and insurance industries, that’s where most of PFF’s holdings come from, too.
This isn’t a fund for capital gains. Yes, people who bought before the financial crisis were slayed, while people who bought at the bottom made a mint, but for the past five years, PFF has traded in a range between $41 and $35.50 – basically a 15% difference from trough to peak.
No, PFF is about one thing: dividends. This is great as a conservative long-term holding, and also appropriate for retirees looking for significant income paid out on a monthly basis.
The Best Index Funds to Buy: iShares Core U.S. Aggregate Bond ETF (AGG)
Type: U.S. Investment-Grade Bonds
Keeping with the domestic income theme, our next index fund is the iShares Core U.S. Aggregate Bond ETF (AGG).
AGG is a very broad play on domestic investment-grade debt — specifically, it has more than 3,000 holdings. The fund’s largest weighting is in U.S. Treasury bonds (37%), though it also is significantly invested in pass-through mortgage-backed securities (25%). The rest of the fund is rounded out by corporate debt, commercial MBSes and other bonds.
The upside to highly rated debt is that there’s a good chance the issuer will repay it, making it a pretty safe investment — U.S. Treasuries in specific are considered among the most secure debt in the world. The downside is that such debt typically doesn’t command very high interest rates, so the yields are fairly modest. AGG itself only has an SEC yield of 1.9% right now.
This makes AGG more of a capital preservation play — not necessarily important when you’re younger, but certainly when you’re at retirement age or just a few years away and want to lock down some of your nest egg while still making more of a return off it than you’d get in savings or a money market fund.
And at 0.08% in fees, AGG is taking only the slightest of nibbles out of your investment funds.
*Includes a 0.01% fee waiver that’s currently in force through June 30, 2015.
The Best Index Funds to Buy: SPDR Barclays High Yield Bond ETF (JNK)
Type: Junk Bonds
Investors also can tap into the bond market for yield via high-yield corporate bonds, though that’s fraught with a little more risk.
Bonds issued with lower investment grades — referred to as “junk” — usually sport high yields to compensate for increased risk in the underlying company. Played individually, these bonds can be pretty dangerous, as there’s a higher probability that the interest and bonds eventually could go unpaid. But, if you spread your risk across a few hundred issues of this debt, and you find yourself in a much safer spot.
That’s what the SPDR Barclays High Yield Bond ETF (JNK) provides — JNK exposes investors to well more than 700 different bond issues, mostly based in the U.S. but also spanning other countries including Luxembourg, Canada and even the Cayman Islands. And it provides this extensive debt diversification while still offering an SEC yield of 6.1%.
But while JNK is one of the best index funds you can use to harness the power of junk debt, and less risky than investing in individual junk bonds, it’s still exposed to a fair amount of danger.
A poor economy can help drive defaults higher, and at a certain point, the losses sustained that way can outweigh the high yields offered by the remaining bonds in the fund. Conversely, though, a roaring economy helps keep defaults low, helping out index funds like JNK. Granted, expanding economies also can be accompanied by rising interest rates, which weighs on other debt including junk … but nonetheless, junk debt typically performs better when the economy is growing and the stock market is heading higher.
The Best Index Funds to Buy: Vanguard FTSE Developed Markets ETF (VEA)
Type: Developed-Market Stocks
If you want to venture outside of the U.S. — and you absolutely should — then look toward the Vanguard FTSE Developed Markets ETF (VEA). This is one of the best index funds for large-cap international exposure, with VEA investing in companies from the developed markets of Europe, the Pacific and the Middle East.
A “developed market” is just a term for a country that has an advanced economy, whose population brings in relatively higher incomes than the rest of the world, and whose markets are considered to be highly regulated. So, the U.S. is a developed market. Morocco … not so much.
In the case of the VEA, it is most heavily invested in the United Kingdom and Japan, with about 40% of the fund dedicated to stocks from those two countries alone. The rest of the fund is distributed among 21 other countries.
The VEA is similar to the SPY in that it provides developed-market exposure to stable, blue-chip companies such as Nestle SA (NSRGY), Royal Dutch Shell plc (ADR) (RDS.A, RDS.B) and Toyota Motor Corp (ADR) (TM). And it even yields more than the SPY by a considerable margin at the moment — 3.5% for VEA vs. just 2% for the SPY.
The Best Index Funds to Buy: iShares MSCI Emerging Markets ETF (EEM)
Type: Emerging-Market Stocks
Whereas developed markets are typically more stable but also less likely to experience breakneck growth, so-called “emerging markets” pack a lot more potential but also can be full of potholes.
The banner EM countries are the “BRICs” — Brazil, Russia, India and, of course, China — but also include countries such as South Africa, South Korea and even Mexico.
The thought behind investing in emerging markets is that the companies there stand to benefit from burgeoning populations and growing wealth. As these economies develop, the middle and upper classes theoretically will expand — and as more citizens have money to spend, that ultimately will benefit the businesses that call these countries home.
With more than $31 billion in assets under management, the iShares MSCI Emerging Markets ETF (EEM) is the current king of the EM funds. EEM is most heavily invested in China, with Chinese companies making up more than a fifth of the fund’s holdings, followed by South Korea (15%) and Taiwan (12%).
However, while the EEM does focus on emerging markets, that doesn’t mean you’re investing in fly-by-night companies you’ve never heard of. There’s electronics giant Samsung (SSNLF) and multinational chipmaker Taiwan Semiconductor (TSM), whose products are used in Apple’s iPads. And telecom China Mobile Ltd. (ADR) (CHL) might not be a big name in the U.S., but it boasts more than 800 million wireless customers.
The Best Index Funds to Buy: Global X Next Emerging & Frontier ETF (EMFM)
Type: Frontier-Market Holdings
Investors certainly should be invested in countries such as China and India, but they might not be the best global growth opportunities.
No, the real boom stories could come from the countries represented in the Global X Next Emerging & Frontier ETF (EMFM).
BRICs are considered “emerging” markets by many, but their economic growth has slowed in recent years. Russian stocks in particular spent the later part of 2014 tanking as declining global oil prices had the Bank of Russia predicting major GDP contraction for next year. However, investors still can find outsize international growth potential by moving into less-ballyhooed emerging markets, and even “frontier markets” — riskier but more rapidly growing than even their EM counterparts.
EMFM is one of just a handful of funds providing exposure to frontier markets, and invests in companies in Indonesia, Kenya, Kazakhstan, Malaysia, Mexico and Turkey, among other countries.
You can look at EMFM as a substitute for EEM, but considering there’s very little overlap between these two funds, you can own both to round out your global exposure. And sure, while EMFM’s expenses of 0.58% are high compared to the rest of this list of the best index funds to buy, it’s still a dirt-cheap way to buy into the farthest reaches of the earth.
Read more about the EMFM here.
The Best Index Funds to Buy: SPDR Gold Shares (GLD)
Doomsday-touting types like to say you should be invested in gold should the whole world go to ruin — after all, paper money won’t be worth anything, and when that happens, precious metals will once again become the currency of choice. (That’s the assumption, anyway.)
Of course, if that’s the case, the SPDR Gold Shares (GLD) — an exchange-traded fund whose shares represent physical gold held in storage elsewhere — would be completely useless to you. State Street is a great fund provider, but when the zombies overrun us, they’re not going to be delivering physical gold to every GLD shareholder.
But as an investment in a normal world, the GLD isn’t a bad holding in small doses.
Gold typically increases in value during times of geopolitical instability — typically a poor time for stocks, making it something of a market hedge. Gold prices also typically head higher during periods of high inflation. Moreover, physical gold actually does enjoy consumer demand across the world, so it’s far from just an investor plaything.
The Best Index Funds to Buy: United States Oil Fund LP (ETF) (USO)
However, if you want to invest in a commodity with far more practical use than gold, considering the United States Oil Fund LP (ETF) (USO).
Now, with USO, there’s no warehouse full of oil barrels — instead, the USO invests in crude oil and other oil-related futures contracts, as well as forwards and swaps, all with the goal of tracking the price of West Texas Intermediate light, sweet crude oil. So, as oil prices go up, so does USO, and vice versa.
However, it should be pointed out that USO and GLD might not be the best long-term investments.
GLD and USO pay out absolutely no dividends, so there’s no chance of even incremental income — meaning they’re only good for capital gains.
That’s not bad in a bubble, but it is when you think about the end game. Consider this: A long-term investment in U.S. stocks is made on the assumption that they’ll grow in perpetuity — and if that happens, it’s because the U.S. economy found ways to continue to expand. That’s generally good if you’re a retiree in America. However, the kinds of events that would send gold or oil up for decades on end from here … well, you’re looking at things like sustained hyperinflation or extremely scarce oil.
At that point, you’ll probably have more to worry about than your IRA.
That’s not to say that USO and GLD aren’t good holdings — they are — but among all these index funds, USO and GLD make a lot more sense from a trading perspective than a long-term buy-and-hold strategy.
Kyle Woodley is the Managing Editor of InvestorPlace.com. As of this writing, he was long EFA, EMFM, JACK, PFF and VOO. Follow him on Twitter at @KyleWoodley.