At this point, we all know the benefits of using index funds as the main building blocks of your portfolio.
Their passive, market-hugging nature provides plenty of diversification benefits and their ultra-low costs have allowed them to outperform the vast bulk of actively managed investment options over long stretches of time.
But being designed to track “the market” doesn’t mean that they are forced to match the market in performance. There are plenty of index funds that actually beat the S&P 500. You just have to be willing to look at something outside index exchange-traded funds like the Vanguard S&P 500 (VOO).
Are they index funds? Yes. Are they tracking the traditional large-cap index? Not by a long shot. And that’s what makes them powerful tools for investors. Adding a splash of these index funds to a portfolio could make all the difference over the longer haul.
Here are seven index funds that are built to beat the S&P 500.
Index Funds Built to Beat the Market: PowerShares QQQ Trust (QQQ)
Expenses: 0.20%, or $20 per $10,000 invested
Over the last five years, the S&P 500 — as measured by the SPDR S&P 500 ETF (SPY) — has managed to put up an over 55% return. That’s not too shabby… that is, until you compare it to the NASDAQ Composite and the PowerShares QQQ Trust’s (QQQ) 83% performance in that time.
The Cubes track the S&P’s “growthier” cousin and includes 100 of the largest domestic and international nonfinancial companies listed on the Nasdaq Stock Market based on market capitalization. And yes, since this the NASDAQ we are talking about, technology plays a huge role in the QQQ’s underlying holdings.
The index fund has about 55% of its portfolio in tech stalwarts like Microsoft Corporation (MSFT) and Apple Inc. (AAPL). But the Cubes aren’t a pure tech fund either. There still is about half of its $37 billion in assets in consumer stocks and healthcare-related equities. And since it’s the NASDAQ we are talking about, these firms aren’t exactly dinosaurs selling toilet paper and breakfast cereal.
The combination of faster-moving tech stocks plus relatively fast-moving consumer stocks has helped power the QQQ’s performance over the years.
For investors, the QQQ’s make for a market-beating combo of large-cap growth. All for expenses of just 0.20%.
Index Funds Built to Beat the Market: Guggenheim S&P 500 Equal Weight ETF (RSP)
Beating the market could be a simple as thinking differently about the S&P 500. And index funds can help you do just that. Case in point, the Guggenheim S&P 500 Equal Weight ETF (RSP).
RSP takes all the stocks in the bread-n-butter S&P 500 and equal weights them — meaning that Exxon Mobil Corporation (XOM) has the same amount of assets in the fund as smaller firm Foot Locker, Inc. (FL).
The problem with the regular S&P 500 funds is that they’re market-cap weighted. Giants like XOM end up having too much pull on the underlying index. It doesn’t matter if FL is having a boffola quarter, if XOM is in the doldrums. By equal weighting the index, these smaller — read: faster-growing — firms have a better chance to show their stuff.
And “show their stuff” they have.
RSP has managed to put up an impressive return versus regular S&P 500 index funds. Over the last 10 years, the Guggenheim S&P 500 Equal Weight ETF has returned nearly 87%. That’s versus just 59% for the previously mentioned SPY.
That even accounts for the RSP’s slightly higher expense ratio of 0.40%.
Index Funds Built to Beat the Market: SPDR S&P MidCap 400 ETF (MDY)
The previous pick — RSP — shows that adding a dose of smaller stocks can beat the market. Perhaps the best way to smash the S&P 500 is to ignore it completely and focus solely on these stocks. And there’s plenty of choice in index funds that do just that.
The SPDR S&P MidCap 400 ETF (MDY) moves down the market-cap ladder and focuses on mid-cap stocks — or those with market caps between $2 billion and $10 billion.
Mid-caps are often considered the market’s “sweet spot.” They’re more established than small-caps and start-ups, which allows them to survive downturns better. Meanwhile, they aren’t as slow growing as large-cap stocks. That offers plenty of chances for profit expansion and share price appreciation.
As a result, mid-caps have been some of the market’s best performers over the long term. And the proof is in the pudding.
MDY — which holds such stocks as Mettler-Toledo International Inc. (MTD) and Everest Re Group Ltd. (RE) — has crushed the S&P 500 over its history. Over the last ten years, MDY has returned nearly 83%. Again, that’s versus the SPY’s 59%, proving that small beats large when it comes to index funds.
MDY charges just 0.25% in expenses.
Index Funds Built to Beat the Market: iShares Russell 2000 Value ETF (IWN)
You know what index funds are even better than mid-caps? Those that focus on small-caps — or stocks with market-caps below $2 billion or so.
But not just any small caps. Small caps with a value tilt.
Research by famed economists Fama & French showed that over long stretches of time, small-cap value stocks have managed to crush pretty much every investment on the planet. Value stocks are defined as those firms with solid fundamentals that are priced below its peers. Measures such as price-to-earnings, yield and other factors can be used to determine value.
The combination of small size, low prices reverting to the mean and the propensity/ability to pay dividends has helped the asset class power portfolios.
The iShares Russell 2000 Value ETF (IWN) is a great way to focus on small-cap value stocks. IWN tracks all the value stocks in the benchmark small-cap index, the Russell 2000. Currently, it holds more than 1,300 different small-cap stocks, including Treehouse Foods Inc. (THS) and Post Holdings Inc (POST).
Performance for the IWN has suffered in recent years as the Great Recession has caused many investors to shun small-cap stocks in general for their larger, “safer” sisters. However, the long-term picture is great. Since 2000 — and the fund’s inception — IWN has managed to return 182%. That’s versus just a 48% return for the SPY.
Index Funds Built to Beat the Market: Vanguard REIT ETF (VNQ)
Index funds can also allow investors to tap various alternative asset classes that have the potential to beat the market. One of the best has been commercial real estate through real estate investment trusts (REITs).
In exchange for lucrative tax benefits, REITs must distributed much of their net income back to shareholder as dividends. Those dividends plus capital appreciation have helped REITs become one of the best total-return elements for investors.
According to industry group NAREIT, REITs have managed to outperform the S&P 500 by 1 to 2 percentages over 15-, 20- and 25-year periods. That outperformance also beats small-caps, bonds and inflation by wide numbers as well.
To that end, investors looking to beat the index may want to consider the Vanguard REIT ETF (VNQ).
VNQ tracks a broad basket of U.S.-based REITs. That includes industry stalwarts like Simon Property Group Inc (SPG) and Prologis Inc (PLD). The ETF offers one of the easiest ways for investors to gain access to the asset class and its long-term outperformance.
And as a Vanguard fund, expenses for VNQ are basically free at just 0.12%.
Index Funds Built to Beat the Market: Vanguard Dividend Appreciation ETF (VIG)
Dividends have been one of the main drivers of the market’s overall returns throughout the long haul. So naturally, index funds that target dividends and dividend-related strategies have been market-beating as well.
The Vanguard Dividend Appreciation ETF (VIG) remains one of the best index funds to tap dividends.
VIG tracks a portfolio of large-cap stocks that have a history of raising their dividends over time. In fact, the index fund’s portfolio targets stocks that have raised their dividends for at least ten years straight. Essentially, VIG whittles down the S&P 500 and gives investors all of its dividend achievers like Microsoft or The Coca-Cola Co (KO).
That’s important, as stocks with histories of raising dividends have actually performed better than stocks with just a high yield or those that offer no dividends. That shows up in the performance data. VIG has returned 64% vs. the SPY’s 59%.
And while the difference in returns may not seem like that much, it is. That extra 4% over the lifetime of the fund could make or break a retirement.
VIG charges just 0.1% in expenses.
Index Funds Built to Beat the Market: SPDR Dow Jones Industrial Average ETF (DIA)
Perhaps investors are just focusing on the wrong measure for their large-cap exposure. The Dow Jones Industrial Average often gets called a flawed index due to its weighting formula. But when it comes to beating the S&P 500, the Dow often succeeds.
The SPDR Dow Jones Industrial Average ETF (DIA) since its inception in 1998 has managed to put up a 134% cumulative return. The S&P 500 SPDR in that time only managed to return 118%.
And there is a lot to like about the DIA besides the outperformance.
For starters, you are gaining access to the arguably the 30 most important stocks in the United States across a variety of sectors. That includes mega-caps like Johnson & Johnson (JNJ) and Goldman Sachs Group Inc (GS).
Secondly, the DIA has the added benefit of paying a higher monthly dividend. Currently, the Diamonds are paying 2.37%. That compares to just a 2.1% yield for the SPY. Not only are you getting a better return, but you are being pad better to own the index fund.
Finally, the DIA is dirt cheap to own at just 0.17% in expenses.
As of this writing, Aaron Levitt was long RSP.