Low-cost index funds can provide wide diversification. This is what the professionals advise.
The expense ratio is one of the inevitable expenses that fund investors face. This charge is continuously subtracted from the total amount of your investment and is stated as an annual percentage.
For instance, you would pay $50 in fees a year if you invested $10,000 in a fund with a 0.5% cost ratio. The management fee is one of the main expenses included in the expenditure ratio. This is essentially how fund managers make their living—by charging for their services in this manner.
The expense ratio isn’t just influenced by the management fee, though. The overall cost for might also be increased by additional elements including portfolio management, administration, marketing, and distribution expenses for investors.
This is especially true for actively managed funds, where fund managers choose and manage portfolios and do in-depth stock research. Due to the large time and resource commitments associated with these tasks, turnover rates are higher, which raises overall expenses.
On the other hand, index funds are a more economical option. By buying all or a representative sampling of the index’s constituent equities, these funds seek to emulate the holdings and performance of a particular benchmark, such as the S&P 500. With this method, investors can experience the risk and return characteristics of the index without having to engage in active management.
Because index funds mirror a benchmark rather than outperform it, they naturally have lower turnover and management costs, which make them a desirable choice for investors looking for broad diversification at a lower cost.
They also put on a strong show when it comes to performing. Examine the most recent findings from the SPIVA scorecard of S&P Dow Jones Indices, which compares actively managed funds against the indices for each of their respective categories. SPIVA discovered that 92.2% of all US large-cap funds underperformed the S&P 500 index over the previous 15 years.
“If you can’t beat ’em, join ’em” is the underlying principle of index investing, according to Robert Johnson, a finance professor at Creighton University’s Heider College of Business. “For the vast majority of investors, the KISS mantra – ‘keep it simple, stupid’ – should guide their investment philosophy.”
Johnson is supported by Rodney Comegys, worldwide head of Vanguard’s stock indexing group: “Beating the market is a zero-sum game; investors cannot all be above average, so it is impossible for investors as a whole to outperform the market.” The long-term performance of investors can be facilitated by index funds because to their relatively predictable returns, low turnover, extensive diversification, and cheap costs.”
Also read this: Top ETFs to Buy Right Now 2024
The top ten inexpensive index funds and exchange-traded funds, or ETFs, to purchase are as follows:
| FUND | EXPENSE RATIO |
| Vanguard Total Stock Market ETF (ticker: VTI) | 0.03% |
| Fidelity Total Market Index Fund (FSKAX) | 0.015% |
| Fidelity ZERO Total Market Index Fund (FZROX) | 0% |
| Vanguard Total World Stock ETF (VT) | 0.07% |
| Vanguard Total World Bond ETF (BNDW) | 0.05% |
| Schwab U.S. Aggregate Bond Index Fund (SWAGX) | 0.04% |
| Vanguard Dividend Appreciation ETF (VIG) | 0.06% |
| iShares S&P 500 Value ETF (IVE) | 0.18% |
| SPDR Portfolio S&P 500 Growth ETF (SPYG) | 0.04% |
| Invesco NASDAQ 100 ETF (QQQM) | 0.15% |
1. Vanguard Total Stock Market ETF (VTI)
“Broad diversification is a fundamental component of indexing, and when it comes to U.S. stocks, it doesn’t get much more diversified than VTI,” according to Comegys. “VTI holds more than 3,700 stocks covering nearly 100% of the investable U.S. stock market and is a core building block in many portfolios.”
All 11 sectors’ worth of large-, mid-, and small-cap U.S. companies are exposed to market-cap weighted exposure through the VTI-tracked CRSP U.S. Total Market Index. The ETF’s efficiency is demonstrated by its extremely low 0.03% cost ratio and 3.4% yearly portfolio turnover rate.
2. Fidelity Total Market Index Fund (FSKAX)
The returns of the market have been driven by a small percentage of big winners,” Johnson says. “For most, trying to pick winners ex-ante is a loser’s game, so the solution is to invest in diversified index funds where you don’t have to pick the winners.” To put this in play, investors can buy FSKAX.
Through the Dow Jones U.S. Total Stock Market Index, this mutual fund offers an alternative strategy for investing in the whole U.S. stock market. There is no minimum investment requirement, a 1% yearly portfolio turnover ratio, and an extremely low 0.015% expense ratio for investors to anticipate.
3. Fidelity ZERO Total Market Index Fund (FZROX)
“Just as how the stock market returns compound, the deleterious effects of high fees and transaction costs also stack up over time,” writes Johnson. “John Bogle, the late chairman and founder of Vanguard, actually dubbed this phenomenon ‘the tyranny of compounding costs.”
Investing in FZROX allows investors to completely remove expense ratios. This fund is a member of the Fidelity ZERO mutual fund family, which has zero percent expense ratios across the board. It follows the private Fidelity U.S. Total Investable Market Index, which is comparable to the Dow Jones U.S. Total Stock Index in terms of content.
4. Vanguard Total World Stock ETF (VT)
“Broad-market index funds use highly efficient investment strategies with minimal portfolio turnover, which means fewer taxable capital gains distributions for investors,” according to Comegys. VT is an excellent illustration of this, as it maintains a low turnover rate of 4.3% even with a portfolio of almost 9,800 equities.
This exchange-traded fund (ETF) tracks the FTSE Global All Cap Index to give investors exposure to the global stock market through a single ticker. It is composed of 60% U.S. companies, 30% developed foreign stocks, and 10% stocks from emerging markets. All of this is available for a cheap expenditure ratio of 0.07%.
5. Vanguard Total World Bond ETF (BNDW)
According to Brian Huckstep, chief investment officer at Advyzon Investment Management, “it is possible to build a simple, diversified portfolio with just two ETFs: a broad market equity index ETF and a diversified bond index ETF.” Investors can purchase BNDW, which offers exposure to international bonds, to supplement VT.
The Bloomberg Global Aggregate Float Adjusted Composite Index is tracked by BNDW. To do this, it divides its portfolio equally between the two underlying Vanguard bond index ETFs, which cover bonds issued in the United States and elsewhere. The cost ratio of the ETF is 0.05%.
6. Schwab U.S. Aggregate Bond Index Fund (SWAGX)
“All else being equal in terms of benchmark and fees, I always prefer a mutual fund,” adds Huckstep. “This is because trading ETFs involves a bid-ask spread, which is an implicit cost that many people do not consider.” Investors looking for a cheap bond index mutual fund may want to look into SWAGX.
This fund follows the Bloomberg U.S. Aggregate Bond Index, which measures the performance of investment-grade corporate bonds, mortgage-backed securities, and thousands of Treasury bonds issued by the US government. It has no minimum investment and has an expense ratio of 0.04%.
7. Vanguard Dividend Appreciation ETF (VIG)
“A consistently increasing dividend can be a signal of a firm’s strong balance sheet, disciplined capital allocation and commitment to returning value to shareholders,” according to Comegys. “VIG offers investors low-cost, diversified access to such companies.” The cost ratio of the ETF is 0.06%.
VIG is a benchmark for the S&P U.S. Dividend Growers Index, which evaluates companies based on a minimum of ten years of dividend growth history and enough market liquidity. Businesses are sorted according to their yearly yield, and the top 25% are eliminated in order to get rid of those with large yields but potentially ephemeral dividends.
8. iShares S&P 500 Value ETF (IVE)
Index investing goes beyond simply following the overall market. Funds can also target particular styles of equities, like growth or value, by using speciality indexes. The latter is shown by IVE, which tracks the S&P 500 Value Index passively for an expense ratio of 0.18%.
The S&P 500 stocks with the best value qualities in terms of price-to-book, price-to-earnings, and price-to-sales ratios are essentially chosen by IVE’s benchmark. Warren Buffett’s conglomerate holding company, Berkshire Hathaway Inc. (BRK.B), is currently its largest holding.
9. SPDR Portfolio S&P 500 Growth ETF (SPYG)
SPYG, which tracks the S&P 500 Growth index, is the inverse of IVE. The companies in this index are chosen based on momentum, price-to-earnings ratio changes, and sales growth that is more than average. It is a low-cost “Portfolio” offering from SPDR with an expense ratio of 0.04%.
The companies in the technology, communication, and consumer discretionary sectors make up a large portion of SPYG’s current portfolio. Alphabet Inc. (GOOG, GOOGL), Amazon.com Inc. (AMZN), Microsoft Corp. (MSFT), Apple Inc. (AAPL), Nvidia Corp. (NVDA), and Meta Platforms Inc. (META) are a few notable top holdings.
10. Invesco NASDAQ 100 ETF (QQQM)
The Nasdaq-100 is another well-liked index that many growth investors like to follow. One hundred of the biggest non-financial sector stocks listed on the Nasdaq market are included in this index. In practice, this means that a large number of America’s top mega-cap tech stocks are exposed to a high degree of risk.
For a 0.15% expense ratio, investors can purchase QQQM to participate in the Nasdaq-100 index. Currently, the top holdings in this ETF are Alphabet, Broadcom Inc. (AVGO), Costco Wholesale Corp. (COST), Apple, Nvidia, Amazon, Meta Platforms, Microsoft, and Tesla Inc. (TSLA).
Tax Efficiency: Advantages of investing in index funds
Lower Turnover Rates: Generally speaking, index funds have lower turnover rates than actively managed funds. This implies that fewer securities are bought and sold by index funds, which lowers the number of taxable events that occur within the fund. Reduced transaction costs and less capital gain realisation result from lower turnover, which can help investors pay less in taxes.
Fewer Capital Gains Distributions: In an effort to beat the market, actively managed funds frequently acquire and sell securities on a regular basis. Therefore, even if they did not sell their shares, they might realise capital gains that are dispersed to shareholders and expose investors to capital gains taxes. On the other hand, because of their buy-and-hold strategy, index funds usually have lower capital gains distributions, which mean that investors have less tax implications.
Tax Loss Harvesting Opportunities: During market downturns, index funds may present investors with opportunity to harvest tax losses. Investors can sell their index fund holdings at a loss to offset capital gains in other sections of their portfolio or against ordinary income in the event of transitory reductions in value. This lowers their overall tax obligations.
Also read this: The Top 7 International Stock Funds to Invest in 2024
Index funds for effective asset allocation
An essential component of investment strategy is asset allocation, and index funds can be useful instruments for putting these plans into practice. The following advice explains how investors can use index funds to allocate their assets:
1. Understanding Asset Classes
Stocks: Stocks have the ability to increase in value and are a representation of ownership in publicly listed corporations. Although they are often regarded as having greater risk, they have traditionally yielded higher long-term returns.
Bonds: Bonds are debt instruments with fixed interest rates and principal repayment upon maturity that are issued by governments or businesses. Though they have a smaller potential return than stocks, bonds are typically thought of as having less risk.
Real estate: Investing in real estate entails holding physical properties or REITs, which offer exposure to the real estate market. Investments in real estate have the ability to provide income through dividends or rent, as well as diversification benefits.
2. Determining Risk Tolerance and Investment Goals
Investors ought to evaluate their risk tolerance, which is a reflection of their capacity and desire to put up with value changes in their investments. Risk tolerance is influenced by a number of factors, including personal circumstances, financial goals, and investment time horizon.
Investment goals differ from person to person and can include things like building wealth, saving for retirement, or paying for college. Objectives ought to be time-bound, relevant, measurable, achievable, and specific (SMART).
3. Constructing a Balanced Portfolio
Depending on the risk tolerance and investing objectives of the investor, a balanced portfolio usually consists of a combination of asset classes. The goal of asset allocation is to diversify across various investment classes and maximise risk-adjusted returns.
According to contemporary portfolio theory, diversity can lower portfolio risk without compromising returns. Maintaining a diverse portfolio of index funds that span multiple asset classes might be advantageous for investors.
4. Implementing Asset Allocation with Index Funds
At a modest cost, index funds provide wide exposure to particular asset classes or market areas. Investing in index funds allows investors to build a diversified portfolio that fits their asset allocation plan.
An investor with a lengthy investment horizon and a moderate risk tolerance, for instance, would divide their portfolio as follows:
–60% of a total stock market index fund should be allocated to both local and foreign equity.
-30% in an index fund that tracks the whole bond market for income generation and diversity.
-To gain exposure to the real estate market, invest 10% in a REIT or real estate index fund.
5. Rebalancing and Monitoring
Maintain the appropriate asset allocation by routinely adjusting the portfolio, particularly when market volatility or changing investment goals occur.
To stay on track with investing goals and risk tolerance, keep an eye on the performance of index funds and alter the allocation as necessary.
Common Misconceptions and Myths
Myth: Active management always outperforms passive index investing.
Reality: While a small percentage of active managers do better than the market, most do not exceed their benchmark indexes over an extended period of time.
Myth: Passive index funds are risk-free investments.
Reality: Even while index funds are less expensive and provide diversification, investors may still lose money in bear markets since they still carry systematic and market risk.
Myth: Active managers can accurately time the market and consistently pick winning stocks.
Reality: It is difficult to time the market and choose stocks, and even experienced active managers find it difficult to regularly beat the market.
Myth: Higher fees equate to better performance.
Reality: Studies have indicated that over extended periods of time, less expensive passive index funds tend to perform better than more expensive actively managed funds.
Myth: Passive index funds are only suitable for conservative investors.
Reality: Because they provide diversity, low expenses, and steady returns over time, passive index funds may be appropriate for investors with a range of risk profiles.
