At this point, it can be daunting trying to find the best index funds to buy. The original idea of index funds was that investors could buy a fund that tracked an index, which in turn provided a representation of the entire market — or at least a very large portion of it.
But as index funds grew in popularity, the number of indices exploded. And while there isn’t a tracking fund for each index, there are now thousands of index-tracking ETFs (exchange-traded funds) in the market.
Overall, more narrow index funds usually don’t offer the two best attributes of index funds: diversification and lower fees. In many cases, they’re not even passive investing at all, but rather active thematic bets on a small basket of stocks.
Those funds run into the same problems facing many individual investors, as detailed by Joshua Della Vedova, assistant professor of finance at the University of San Diego School of Business:
“Portfolio management can be very difficult task for individual investors. Unsophisticated investors are prone to making behavioral errors when considering individual stocks, such as buying attention-grabbing stocks, selling winners/holding losers and being confused by the stock ticker (e.g., ZOOM vs ZM). This challenge increases substantially as you look to move beyond a single stock towards a multi-stock portfolio…
Index funds or Exchange Traded Funds (ETFs) can provide a simple and cost effective approach to address many of these problems. Firstly, most ETFs select an underlying market and track it as closely as possible, providing you with a diversified market return at a very low fee. If you were to try and track a market yourself it would be much more challenging and may require frequent rebalancing, which can be costly in terms of brokerage fees and time…Overall, the diversification and simplicity of ETFs and index funds is the reason there is over four trillion dollars invested in them globally.”
For investors looking for the best index funds to buy, then, it helps to keep it broad and simple. And these four index funds are a wonderful place to start:
- SPDR S&P 500 ETF Trust (NYSEARCA:SPY)
- Invesco QQQ ETF (NASDAQ:QQQ)
- iShares Russell 2000 ETF (NYSEARCA:IWM)
- Vanguard FTSE All-World ex-US ETF (NYSEARCA:VEU)
So, let’s dive in and take a look at each one.
Best Index Funds to Buy: SPDR S&P 500 ETF Trust (SPY)
It’s perhaps easiest to start with the granddaddy of them all. But that’s not true, exactly: the first index fund actually was the Vanguard 500 Index Fund, launched in 1975.
However, the SPY tracks the S&P 500 Index while trading on an exchange instead of through brokers. The S&P 500 consists of 500 large American companies, though not necessarily the largest.
Put simply, the S&P 500 is the most commonly-used benchmark for fund managers and institutional investors. It isn’t necessarily “the market” in that it only covers about 7% of all US-listed stocks. But it’s still often referred to as “the market” because it’s an excellent reflection of sentiment and performance; Better, in fact, than the Dow Jones Industrial Average, which contains just 30 companies.
As a result, the SPY should be a cornerstone of a passive portfolio. And if the goal is to have low fees, the SPY fits the bill: the gross expense ratio is less than a tenth of a percent. If the goal is diversification, the SPY too hits the market. The ETF even offers a dividend yield of 1.7% at the moment, providing some income.
So, with all of that in mind, this is where investors looking for the best index funds to buy should start.
Invesco QQQ ETF (QQQ)
That said, the S&P 500 isn’t the only major index worth tracking. And in recent years, it hasn’t even been the best.
That honor goes to the NASDAQ-100. That index consists of 100 of the largest non-financial companies that trade on the NASDAQ Exchange. (Owing to dual-class stocks like Alphabet (NASDAQ:GOOG,NASDAQ:GOOGL), it actually has 103 stocks.)
The NASDAQ long is the exchange of choice for tech companies, and so the QQQ is heavily weighted toward tech. The top five holdings in order are Apple (NASDAQ:AAPL), Microsoft (NASDAQ:MSFT), Amazon (NASDAQ:AMZN), Facebook (NASDAQ:FB) and Tesla (NASDAQ:TSLA). The latter, in fact, is not yet in the S&P 500, despite meeting requirements for entry after its most recent quarter.
As tech — and large-cap tech in particular — has led the rally off 2009 lows, QQQ has outperformed. Over the past decade, it’s returned 445%, more than double the S&P 500’s 190%.
Obviously, investors in QQQ are betting that the trend will continue. And there is some concentration risk here: AMZN, MSFT and AAPL stocks now account for one-third of the index. But more aggressive and/or younger investors likely are looking to take on more risk for more returns, and at least in recent years QQQ has delivered.
Best Index Funds to Buy: iShares Russell 2000 ETF (IWM)
Again, diversification is a prime consideration when considering the best index funds. The point of passive investing is to benefit from the long-term returns of the market as a whole, rather than trying to pick winners and losers.
That said, the Russell 2000 offers more diversification than most well-known indexes. As the name suggests, it includes some 2000 equities. But it’s worth noting the index’s focus: small-cap stocks. As of May 8, the largest market capitalization of any Russell 2000 constituent was just $4.4 billion. The weighted average is under $1.9 billion.
That focus creates reward — and risk. Obviously, the index will include many big winners, as it’s far easier for a stock to triple (or better) from a $2 billion market value than from the nearly $2 trillion value currently assigned Apple. And small-cap companies ostensibly should outperform over time, as they have more growth potential than the mature companies in the S&P 500, in particular.
However, we’ve seen the risks in 2020. Small-cap companies are more likely to struggle in a negative environment, and mature companies simply offer much more in the way of stability.
Indeed, IWM is down about 12% so far this year, while SPY is positive and the QQQ has gained 26%. It’s possible that trend reverses as normalcy returns, but it’s also possible that bigger will be better for some time to come.
Vanguard FTSE All-World ex-US ETF (VEU)
Many investors do (and probably should) want international exposure as well. U.S. markets remain the gold standard, and U.S. stocks have substantially outperformed over the past decade. But with valuation questions dogging American equities, it’s worth at least considering cheaper funds in both developed and emerging foreign markets.
That said, VEU is perhaps the simplest way to get that exposure. As the name suggests, the fund owns stocks worldwide with the exception of the U.S. About 40% of the portfolio is allocated toward European stocks, while roughly one-quarter comes from emerging markets. Well-known holdings include Alibaba (NYSE:BABA), Nestle (OTCMKTS:NSRGY), and Samsung, with the top 10 holdings comprising about 10% of the fund.
Expenses are low, at just 0.08%. It also pays distributions quarterly, but it’s worth noting they are notably uneven. Many non-American companies avoid the fixed quarterly dividend policies that are the norm domestically: VEU distributed $0.5814 per share in December and just $0.1177 three months later, amid the height of the coronavirus pandemic.
Again, international stocks have underperformed U.S. equities, and VEU has been no exception. It’s returned just 9% over the past decade, badly lagging American benchmarks. But for investors seeking international exposure going forward, this still is one of the top funds to consider.
On the date of publication, Vince Martin did not have (either directly or indirectly) any positions in the securities mentioned in this article.
After spending time at a retail brokerage, Vince Martin has covered the financial industry for close to a decade for InvestorPlace.com and other outlets.