Index funds: Countless investors have benefited from the rise of these passive investments, but perhaps no group enjoys the perks more than those planning for (or already in) retirement?
Geez, where do you begin? Index funds typically outperform active management (not as much as advertised, but enough that it counts). They’re dirt cheap because you’re not paying an office full of advisors. They save you even more money when you consider they typically don’t turn over their portfolios as much as many active investors.
And index funds keep emotions in check — an oft-forgot piece of advice, but an important one that helps prevent costly blow-ups.
Warren Buffett is constantly cited as one of index funds’ greatest proponents, but a couple of other financial brains tout index funds, too. Peter Lynch, Charles Schwab, Vanguard founder John Bogle. Granted, the latter two have a lot of skin in the indexing game … but they steered their offerings there for a reason.
Since we’re focusing on retirement (including investors who are already there), today we’ll look at seven of the best index funds (four stock funds, and three bond funds) you could use in a portfolio that focuses mostly on keeping risk to a minimum and also generating steady streams of income.
Best Index Funds for Retirement: Vanguard S&P 500 ETF (VOO)
Type: U.S. Large-Cap Stock
Expenses: 0.05%, or $5 for every $10,000 invested
Warren Buffett has long praised index funds, and even wagered in 2008 that the Vanguard 500 Index Fund Admiral Class (MUTF:VFIAX) — a Vanguard mutual fund tracking the S&P 500 — would beat a collection of hedge funds over the course of a decade.
As of February’s update, he was up by more than 40 percentage points.
So why track the S&P 500? In short, because it’s a collection of U.S. large-cap stocks across all the major sectors, representing a good balance of defense and growth, not to mention decent (not great, but decent) income in the form of a 2% yield. And, when it comes to active managers pursuing a similar strategy, the vast majority fall short.
If the market’s that hard to beat, why not just invest in the market?
The argument becomes even more compelling when you consider that at just 0.05% in expenses, Vanguard’s fund is the cheapest S&P 500 tracker, and the second cheapest large-cap fund next to the Schwab U S Large Cap ETF (NYSEARCA:SCHX), which is just a basis point cheaper.
That said, VFIAX does require a $10,000 minimum investment. If you don’t have that to spend initially, your play here is the Vanguard S&P 500 ETF (NYSEARCA:VOO) — this is the exchange-traded version, which costs the same, and has no minimum investment.
Best Index Funds for Retirement: iShares Select Dividend ETF (DVY)
Type: U.S. Dividend Stock
The iShares Select Dividend ETF (NYSEARCA:DVY) is fairly unremarkable as far as dividend index funds are concerned, and that’s OK by me.
DVY tracks an index containing stocks that “have provided relatively high dividend yields on a consistent basis over time.” The “over time” part of it is a little sketchy, as the benchmark for consecutive dividend increases is a minimum of just five years, but it also enforces some quality control such as an average dividend coverage ratio of 167%, and positive trailing earnings.
This results in a utilities-heavy blend of large- and mid-cap stocks, though its top holdings are all outside the sector. Currently, Lockheed Martin Corporation (NYSE:LMT), Chevron Corporation (NYSE:CVX) and Philip Morris International Inc. (NYSE:PM) hold the greatest weights in DVY. Also attractive is that the biggest of the fund’s 100 holdings — LMT — has a weight of just 3.5%, so risk is very evenly spread out across the board.
The iShares Dividend Select ETF yields roughly 3% and has a beta of about two-thirds the market; simply put, when the S&P 500 wiggles, DVY doesn’t waggle quite so much.
Best Index Funds for Retirement: WisdomTree International Large Cap Dividend Fund (DOL)
Type: International Large-Cap Stock
The WisdomTree International Large Cap Dividend Fund (NYSEARCA:DOL) is another fund that focuses heavily on market behemoths, this time in international waters. The DOL holds 300 companies outside of the U.S. and Canada, and are weighted by their annual cash dividends paid.
The DOL is very geographically diverse — while the United Kingdom does have a large weighting at 20%, this index fund also has 10%-12% weightings in France, Japan, Australia and Switzerland — so, you’ve got three continents represented in the top five countries alone, and two of the three European countries are outside the eurozone.
DOL’s top holdings are the kind of big, sturdy dividend payers you’d expect, such as Nestle SA (OTCMKTS:NSRGY) and Novartis AG (ADR) (NYSE:NVS) … and while China Mobile Ltd. (ADR) (NYSE:CHL) isn’t a household name, it is a $300 billion telecom with a 2.7% yield (one that only looks so low because the stock has ramped up some 50% in a year).
This translates into a trailing dividend yield of 3.6% currently. However, investors should know that DOL’s payout varies greatly from quarter to quarter, so while this WisdomTree fund is a good source of income, it’s not a fund you can necessarily plan around to the dollar.
As a note: There is an iShares International Select Dividend ETF (NYSEARCA:IDV) that has similar features to the previously discussed DVY, but DOL gets the nod here as DVY has an outsized (30%-plus) allocation to Australia, which is just a lot of single-country risk, but particularly tricky considering how tethered to China’s economy it is.
Best Index Funds for Retirement: Market Vectors Preferred Securities ex Financials ETF (PFXF)
Type: Preferred Stock
I’ve been banging the drum of preferred stocks for some time, and they remain one of my favorite methods of getting investment income.
I talk about preferred stocks more in-depth here, but in short, these essentially are like stock-bond hybrids. The key features? They pay large, fixed dividends, and these dividends actually have priority over common-stock dividends in the event of a financial emergency.
I’m currently long the iShares U.S. Preferred Stock ETF (NYSEARCA:PFF) — it’s the largest among preferred stock index funds, it’s cheap at 0.47% in expenses, and it yields roughly 6%.
That said, many investors grew a great deal of distrust for the banking sector amid the 2007-09 mortgage and financial crisis, which gave way to products like the Market Vectors Preferred Securities ex Financials ETF (NYSEARCA:PFXF). That’s something of a hang-up if you want to invest in preferred shares, as most funds invest in preferreds from big banks and other financial stocks.
However, PFXF is exactly what it sounds like — a preferred stock ETF that invest in anything but financials, instead putting the most of its heft into preferreds from real estate investment trusts, electric utilities and telecom companies. Top holdings are preferred stocks from Southwestern Energy Company (NYSE:SWN), Tyson Foods, Inc. (NYSE:TSN) and United Technologies Corporation (NYSE:UTX).
Like PFF, PFXF pays out monthly dividends, and it has a similarly high yield of 5.6%. It’s also cheaper than PFF at 0.4%. To me, it’s frankly a tossup — both PFF and PFXF will be susceptible to a wide market crash — but if you want to try to back out the risk of another collapse in financials, PFXF is an ample source of income.
Best Index Funds for Retirement: Vanguard Short-Term Government Bond ETF (VGSH)
Type: Short-Duration U.S. Bonds
Last year, Warren Buffett outlined some advice about how his trustee should invest the money Buffett plans to leave for his wife:
“My advice to the trustee could not be more simple: Put 10 percent of the cash in short-term government bonds and 90 percent in a very low-cost S&P 500 index fund. (I suggest Vanguard’s.)”
We’ve already covered the S&P 500 index fund with the VOO, and we can go right back to Vanguard for a low-cost index fund to get invested into short-term government bonds: The Vanguard Short-Term Government Bond ETF (NASDAQ:VGSH).
For a mere 0.12% in expenses, investors get access to nearly 150 bonds with maturities of between one and three years — the vast majority of it U.S. Treasury debt, and the rest is other debt guaranteed by the U.S. government debt.
Short-term bonds traditionally are a safety play. While short-term government bonds aren’t going to make you much in the way of income (VGSH yields a paltry 0.5%), they’re exposed to less interest-rate risk than longer-duration bonds when interest rates rise, and there’s little credit risk as U.S. debt is rated among the best in the world.
But a fair warning about this and any other bond fund. Interest rates have been sitting in the basement for some time, and we’re finally starting to see real expectations for rate hikes within the next year. VGSH isn’t entirely immune from rate hikes, so it and any other bond fund could be at risk — as bond prices fall when interest rates rise — within the intermediate-term.
Of course, that only matters when you’re looking to sell. And while VGSH might decline amid rising rates, its yield should tick up somewhat to at least partially offset the losses.
Best Index Funds for Retirement: iShares iBoxx $ Investment Grade Corporate Bond ETF (LQD)
Type: Investment-Grade Corporate Bonds
Investment-grade corporate debt is another bond play with safety in mind. While bonds issued by Verizon Communications, Inc. (NYSE:VZ) and JPMorgan Chase & Co. (NYSE:JPM) might not be as iron-clad as debt issued by the U.S. government, it’s still very likely to be repaid.
The upside is that this additional single-company risk results in much better yields. But of course it’s a lot less risky for anyone who invest via index funds; in the case of the iShares iBoxx $ Investment Grade Corporate Bond ETF (NYSEARCA:LQD), you’re exposed to 1,346 different holdings, but you’re still enjoying a roughly 3% yield.
Again, there’s interest-rate in LQD — if investors believe they can get a higher yield via safer Treasuries, they will, which will in turn drive down this iShares fund. Still, you’re getting considerable yield until that happens.
Best Index Funds for Retirement: SPDR Barclays Short Term High Yield Bond ETF (SJNK)
Type: Short-Duration Junk Bonds
If you’re talking about bonds and you hear the term “high yield,” the term “junk” is typically close in tow. That’s what junk debt is — somewhat riskier debt that, in order to entice investors, typically yields much more than investment-grade debt.
Naturally, then, when interest rates rise on government debt, junk bonds can get slaughtered. If you can pick up reasonable yield from the U.S. government, why take a gamble on debt that the ratings agencies aren’t so hot on?
That’s where the SPDR Barclays Short Term High Yield Bond ETF (NYSEARCA:SJNK) might have an advantage. This SPDR series trust involves in junk debt, but junk debt with short maturities; in the case of SJNK, it will invest in debt with a maturity of up to five years, with a current average maturity of 3.3 years.
The upside of this kind of debt is that it still offers pretty high yield — as of this writing, the 30-day SEC yield was a healthy 5.2% — so that alone should help buffer it somewhat from rising rates. And, like VGSH, the shorter maturities should provide even more protection.
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