EVERY WEEK WE
debate or perhaps argue is the better word over which funds deserve a spot in your retirement account. The discussion can get spirited when we bring up narrowly-focused sector funds, emerging markets or hot themes like alternative energy and water. But one fund category that everybody agrees on is index funds. These low-cost, broad-based offerings deserve a spot in every portfolio.
This week we searched our database for some of the industry's best domestic equity index funds. These are the anchors of your portfolio, typically accounting for over 50% of your U.S.-based stock exposure, if not more. After starting with around 1,100 candidates, we screened for consistent performance and low fees and came up with nine finalists.
You'll find two main types of index funds on our list. The first group revolves around the Standard & Poor's 500 index, one of the most widely-followed stock benchmarks. When we mention a fund beating the returns of the broad market, we mean the gains posted by the S&P 500. We also included what are called "total stock market" funds. These offerings mimic the Wilshire 5000, a benchmark that tries to encapsulate almost every tradable domestic equity stock. Both types make excellent centerpieces for your portfolio.
As usual, we threw out load funds. But the decision to do so wasn't as clear-cut this week. We think it's only appropriate to pay a sales charge when you're getting good advice from a planner, buying a fund with a competent and active manager and planning on holding it for the years it takes to make back that initial cost. With index funds, an advisor doesn't have to do much homework and there won't be a stock picker at the helm. Investors may hold these funds for the long haul but we think with so many cheaper options out there, paying a sales charge is just money down the drain. "You pay a load because you are presumably buying good management," says John Merrill, founder of Tanglewood Capital Management in Houston. "If you are buying an index fund I don't know why you would pay it."
Lately, the index funds on our list have been dealing with an increasing amount of competition for your hard-earned cash. Some advisors opt to shift between funds that track Russell growth and value indexes, depending on which style is the more attractive buy. However, the index funds that are really getting a lot of buzz are those in the exchange-traded fund world.
Traditional index funds use market capitalization the stock price multiplied by the number of outstanding shares to weight the individual companies in their portfolios. The larger the market cap, the bigger the weighting. Those supporting new-fangled ETFs argue that the traditional system can hurt shareholders because it actually gives more credence to hot stocks that might be going through a temporary run-up in price. As investors bid up the shares, the index adds to its weighting. The situation turns ugly when the stock inevitably falls and shareholders are left holding a large position in a crummy stock.
To counter that phenomenon, the Rydex S&P 500 Equal Weight ETF gives the same 0.2% billing to every stock it owns. Another ETF, the PowerShares FTSE RAFI U.S. 1000, uses book value, revenues, cash flow and dividends to dictate its weightings. These two funds own the same companies as traditional index funds, but those slight differences in weighting in many cases its just a half percentage point make a big difference across an entire portfolio of 500 or 1,000 stocks. Both Rydex and PowerShares claim their methodologies could mean an extra percentage point or two of return over the long haul (although the funds haven't established a long enough track record to prove that).
While an extra percentage point of returns is a big deal in the index fund world, we tend to put a heavier emphasis on fees. Our list only focuses on domestic equity index funds and we deem anything over a 0.50% expense ratio excessive. (You should be prepared to pay more for index funds that are based on international or emerging markets.) That said, when it comes to low-cost, domestic equity funds, investors can't go wrong with two offerings from Vanguard.
The Vanguard 500 is the oldest index fund on the market. For the past 31 years it's delivered the returns of the broad market while charging some of the cheapest fees around. Indeed, the fund's 0.18% annual expense ratio an already dirt-cheap rate drops to half that amount if investors can pony up $100,000 or have been in the fund for over 10 years and have accumulated $50,000 in assets. Vanguard 500's top holdings include Exxon Mobil, General Electric, AT&T and Microsoft. When you compare the attributes of this fund, like its fees and its 12.2% average annual return since inception with those of its active and passive counterparts, there isn't a single fund that beats it.
However, we have> been warming up to a sister fund called Vanguard Total Stock Market. This fund owns 3,650 stocks. Its top holdings resemble those in S&P 500-type funds, but it also has 30% of its assets in mid-, small- and micro-sized companies. That means shareholders are getting instant diversification instead of having to buy separate funds that specialize in all those types of stocks. It also means returns can be juiced when small caps and midcaps are heating up. Indeed, that's been the case for years now: Total Stock Market has beaten the average returns of the S&P 500 over the past five years.
The index funds on our list don't charge a load, require a minimum investment under $5,000 and charge an annual expense ratio less than 0.50%. The funds had to have consistent returns as measured by Lipper's standard deviation metric and those gains had to put the funds in the top half of their peer group over the previous three- and five-year time periods.
Note: Data as of Oct. 11, 2007
The Index Fund Screen Recipe
| Fund Classification = large cal S&P 500; multi cap core* Annualized 3-Year Return (%) = Display Only Rank in Classification (%) (3 year performance) <= 50 Annualized 5-Year Return (%) = Display Only Rank in Classification (%) (5 year performance) <= 50 Expense Ratio <= .5% Load Fund (type) = no load Minimum Initial Investment <= 5,000 Open to New Investors = Yes Total Net Assets ($ millions) >=50 1-Year Return (%) = Display Only Rank in Classification (%) (1 year performance) = n/a Annualized 10-Year Return (%) = n/a Rank in Classification (%) (10 year performance) = n/a Return-Since-Inception (%) = n/a Year-to-Date Return (%) = n/a 3-Month Return (%) = n/a Manager's Tenure = n/a Trailing 12 mo. Yield = n/a|
* Ran the screen once for each classification