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The case for index investing is easy to grasp: Mutual funds and exchange-traded funds (ETFs) that simply aim to replicate the performance of major indexes tend to deliver better long-term performance than player managed funds with a similar focus, at a fraction of the cost. As this simple argument has gained traction, index funds and ETFs have grown from less than 20% of all investor assets in 2010 to 40% at the end of 2020.
Yet choosing the right fund can be challenging, especially given the rapidly multiplying number of options available. In a recent report, Morningstar identified nearly 200 large-cap blend funds that could provide the foundation of a well-diversified portfolio. So, how do you choose the best one for you?
Pick Index Funds with the Lowest Expense Ratios
The majority of index funds and ETFs charge an annual fee called an expense ratio. This small fee covers the operating expenses for a fund. (Yes, even though index funds simply seek to emulate the performance and composition of existing indexes, there are still costs associated with buying and selling the investments they hold, among other things.)
It’s not exactly transparent that you’re paying an expense ratio as there’s no line item on your regular fund statements that shows how much the fee cost you. Instead, it’s a percentage of the fund assets that is automatically deducted from your returns.
“With indexing, fees are everything,” says Daniel Hawley, a financial advisor in Walnut Creek, Calif. “Once you identify an investment category you want to use indexing in, look for the fund or ETF with the lowest expense ratio.”
Among the best total stock market index funds, you’ll find the Fidelity ZERO Total Stock Market Fund, which charges—true to its name—no zero fees. Schwab’s Total Stock Market Index levies a 0.03% expense ratio, and the Vanguard Total Stock Market Fund charges an annual expense ratio of 0.04%. Those uber low expense ratios may work out better for you than similar funds charging higher fees over time.
Check out the math. If you were to invest $10,000 a year over a 10-year period, earning a gross return of 8%, you would end up with around $151,000 if the expense ratio was 0.63%. If the strategy expense ratio for another fund tracking the same index pursuing the same was only 0.04%, you’d have more than $156,000. That’s a $5,000 difference, based on nothing more than fees. Now imagine how that can multiply over the course of a 30- or 40-year investment timeline.
Don’t Sweat the ETF vs. Index Fund Difference
When you’re shopping for funds that passively track an underlying index, you may start wondering what the difference between an index fund and an ETF is—and, more importantly, if it matters. Practically speaking, what separates an index fund from an ETF really comes down to how frequently the share price of the fund changes.
With an index mutual fund, you can place an order at any time, but the price of your purchase or sale will be based on the value of all the underlying securities at the close of the current trading day. If you place an order after the market has closed (4 pm ET for US exchanges), your trade will be processed at the closing price on the following trading day.
An ETF trades just like a stock, and its price changes throughout the trading day. Assuming you can buy and sell ETF and mutual fund without paying a commission—that’s common at the best brokerages these days—it hardly matters which type of fund you choose, so long as it’s low cost.
That said, if you’re just getting started investing on your own, whether in an IRA or a regular taxable account, an ETF can be the more practical choice.
Many mutual funds require a minimum initial investment that can be $1,000 or more. But if you open an account at a brokerage you can get rolling with an initial investment of just one ETF share, which is typically going to be a lot less than a fund minimum. You may even be able to get started purchasing just a fractional share of an ETF.
Moreover, ETFs often have an expense ratio advantage. Sometimes it’s hairsplitting: The Vanguard Total Stock Market ETF has a 0.03% expense ratio and the mutual fund version charges 0.04%.
Sometimes it’s more than a few hairs: The iShares S&P 500 index ETF charges an 0.09% expense ratio while the mutual fund version’s investor share class charges 0.35%. When deciding between mutual funds and ETFs, though, one basic point remains: Opt for whichever vehicle allows you to recreate an cheapest index.
How Index Funds Work Best in a Portfolio
There are different ways to employ funds in an investment or retirement portfolio. You can exclusively rely on indexing—that’s the approach robo-advisors go for, typically with ETFs. Alternatively, you can mix index funds with actively managed funds.
Hawley uses the “core and explore” approach for his client’s portfolios. Low-cost index funds and ETFs are the foundation, but he also chooses some actively managed funds that he expects will deliver more compelling risk-reward opportunities.
Whatever approach you choose, the key is to emphasize indexing in the parts of the market that are what is often referred to as being “efficient.” That’s trade-speak for a market where there’s so much available information and seamless trading that it’s hard for active management to outperform.
Morningstar’s Active/Passive Barometer report compares the average performance of index funds in a specific investment category to the performance of actively managed funds. Across all categories, fewer than one in four active funds outperformed their index counterparts in the 10 years through 2020.
In the most efficient markets, indexing was even stronger. Just 8.4% of actively managed large-cap blend funds, 9.3% of large-cap growth funds and 14% of large value funds managed to outperform their indexing counterparties in the 10 years through 2020. Fewer than three in 10 of intermediate core bond funds outpaced index funds in the category.
In markets where there’s less uniform information available, or a less uniform trading platform, active management has a better track record. Over the past 10 years, more than 40% of active funds investing in emerging stock markets, high-yield bonds, corporate bonds, real estate and US small-cap and mid-cap growth outperformed index funds.
How to Build a Portfolio with Index Funds
If you want to keep things simple, you can build an all-index portfolio with just one fund. If you’d like more control over your asset allocation mix, you can get the job done with just two or three funds.
- Choose one target date fund. For a retirement portfolio, you can choose a target date fund. All you need is one fund with a year in its title that’s close to when you’ll be turning 65. That’s it; you’re done. The target date fund handles all the heaving lifting, investing in a mix of stock and bond funds or ETFs based on your investment timeline. Many target date funds exclusively use low-cost index funds and index ETFs.
- Take the three-fund approach. Another simple approach is to create a three-fund portfolio that includes a total stock market index fund, an international stock index fund and a high-grade US bond index fund. This allows you to customize your equity-to-bond ratio more but requires you to be slightly more hands on than you would with a target date fund.