Do you know the real secret to outperformance, great returns and beating the vast bulk of investors? The answer is just owning the “market.” That’s right. Buying everything. Using index funds for the core of your portfolio just makes sense. And there’s plenty of research that shows just how powerful index funds can be.
A recent Morningstar study indicates that actively managed funds, both exchange-traded funds and mutual funds, lagged index funds across nearly all asset classes from 2004 to 2014. Of the 12 fund categories, Morningstar studied, only those active funds that invest in value stocks of mid-sized companies had a ten-year success rate above 50% when compared to index funds. And even then, it wasn’t that good.
Part of the reason for their outperformance comes down to the fact that index funds are dirt cheap to operate. Lower trading and administration costs equal lower expense ratios for you and me. The other part comes down to market timing. Because index funds own all the stocks within a particular market segment, there’s no guesswork on the best time to buy. In fact, trying to time the market to avoid losses and maximize gains turns out to be one of the worse things you can do.
All in all, index funds make an ideal choice for all investors. Here are three that no portfolio should be without.
Great Index Funds for Your Core Portfolio: iShares S&P 1500 Index Fund (ETF) (ITOT)
Expense Ratio: 0.03%, or $3 per $10,000 invested
When it comes to stocks, the United States still dominates regarding world market capitalization. As a result, it probably should have a dominating place in all of our portfolios. And the best way to get that exposure through index funds is the iShares Core S&P Total U.S. Stock Market ETF (NYSEARCA:ITOT).
ITOT tracks the S&P Total Market Index, which provides exposure to the entire U.S. stock market. That includes everything from mega-caps like Apple Inc. (NASDAQ:AAPL) to the smallest of the small-fries, such as Schmitt Industries, Inc. (NASDAQ:SMIT). Overall, ITOT’s nearly 3,700 holdings cover roughly 90% of the stocks domiciled in the U.S.
As its marketing moniker implies, ITOT is a great core index fund that investors can buy periodically and continuously throughout the year. ITOT has proven to be a winner on that front. Over the last decade through the end of February, the index fund has managed to provide a 7.62% annual total return.
Perhaps even better for investors, ITOT is one of the cheapest index funds around to own. Expenses for core holding come in at just 0.03%.
Great Index Funds for Your Core Portfolio: Vanguard FTSE All-World ex-US ETF (VEU)
Expense Ratio: 0.11%
Even though the U.S. is still the No.1 horse in the race, the rest of the world is catching up. Where a company is located has less to do with where it gets its revenues. After all, there’s a pretty good chance you own a Korean-made television or drive a German car.
So adding a dash of international stocks makes plenty of sense. And index funds make adding this dash quick and painless.
Low-cost leader Vanguard has some of the best international index funds around, and the Vanguard FTSE All-World ex-US ETF (NYSEARCA:VEU) is an ideal core holding.
VEU tracks the FTSE All-World ex US Index. This index tracks the return of large- and mid-cap stocks located outside the United States. Over 50 different countries are represented in VEU’s 2,570 different holdings. The real beauty is that its 50 countries include both developed nations as well as emerging markets. That makes getting exposure to Germany’s multinationals and China’s fast growers accessible with one ticker.
Returns for VEU have been less than ideal, returning only 1.42% annually since 2007. Most of that poor return has more to do with the dollar/FOREX, rather than underlying stock performance. But the dollar hasn’t always been on top, and VEU should do better if/when the dollar starts to sink again.
Overall, VEU’s portfolio is chock-full of international stocks that are household names and multinationals. That makes it a great index fund to buy for your core portfolio, especially with the expense ratio of only 0.11%.
Great Index Funds for Your Core Portfolio: Vanguard Short-Term Bond ETF (BSV)
Expense Ratio: 0.9%
A lot has been written about the death of bonds thanks to rising interest rates. That’s because bonds have an inverse relationship with rates. As rates rise, bond prices fall. But bonds do provide plenty of ballast to a portfolio when stocks happen to take a tumble, so having them in your core makes sense.
The key isn’t to choose a broad bond fund like the iShares Core U.S. Aggregate Bond ETF (NYSEARCA:AGG). You’ll get killed as rates rise. The key is to shorten your duration to protect yourself against the Federal Reserve.
The Vanguard Short-Term Bond ETF (NYSEARCA:BSV) uses the Bloomberg Barclays U.S. 1–5 Year Government/Credit Float Adjusted Index as its benchmark. That index provides exposure to short-term, investment-grade U.S. bond market. That includes Treasury and corporate bonds for a total of 2,435 different fixed-income securities.
The real benefit in using BSV over AGG is that the index fund will have an easier time rolling over its bonds due to the shorter maturity mandate. This lower duration should help BSV stand its own against rising interest rates and be the portfolio ballast that bonds are supposed to be.
Even better is that it charges a rock-bottom Vanguard expense ratio of 0.09%.
As of this writing, Aaron Levitt was long ITOT.