If you are looking to diversify your investment portfolio, an index fund is an excellent mechanism to achieve these goals. Unlike a more traditional management fund, whereby fund managers will independently select investment products on your behalf, an index fund instead tracks the performance of a particular market.
Once such example of this is the S&P 500, which is an index that tracks the rise and fall of the top 500 U.S. stocks by market capitalization. However, if this wasn’t confusing enough, if you are looking to invest independently, there are numerous S&P 500 funds to choose from.
In our comprehensive guide, we’ll briefly start by discussing what both an index and the S&P 500 actually are, followed by an overview of some of the most notable funds currently in the market.
What is an Index fund?
In its most basic form, an index fund is a financial investment product that allows investors to speculate on the movement of a specific market. When broken down, the index is the tool used to track the prices of the financial component, and the fund is the avenue that allows you to invest.
In order to calculate the value of an index, a range of underlying mechanisms are utilized. This is to ensure that prices are based on a weighted ‘Float Market Capitalization’ system. In layman terms, this means that the price of an index is based on free-market economics and thus, cannot be manipulated or misrepresented in any way.
Furthermore, much in the same way as traditional stock markets such as the NYSE or NASDAQ, index funds operate in a highly stringent regulatory arena. Index funds can track virtually any market, however the most popular are focused on major stock exchanges. This includes the NASDAQ, FTSE and of course, the S&P 500.
Read: What is the FTSE 100?
What is the S&P 500?
As noted above, the S&P 500 is an index that tracks the movement of the top 500 U.S. companies. The idea behind such an investment is that you get to diversify your risk across 500 different companies, who themselves will be operating in multiple industries.
As such, even if a small proportion of companies underperform, your exposure is significantly reduced, not least because your portfolio contains a sizeable number of individual firms.
As the overall weighted value of the S&P 500 is based on the real-time values of the underlying constituents, the value of the index changes throughout the trading day. However, such an index is more suited for long-term holdings, as in theory, the stock markets should, whilst experiencing turbulence along the way, rise on an indefinite basis.
To give you an idea of what sort of returns the S&P generates, it is important to look at its historical records. Since the Composite index begin in 1926 (although this was just 90 stocks as opposed to 500), annual returns have averaged in the region on 10%. However, it is also important to note that other factors also need to be considered. For example, this can include the effects of inflation, as well as the underlying fees for the fund in question.
Moreover, we should also note that past performance is in no way an indication of future results.
Nevertheless, in the next section of our guide, we’ll discuss the the importance of the expense ratio offered by a S&P 500 index fund.
Chart showing the S&P 500 Returns over the last 5 years
What is an Expense Ratio and why is it Important?
No matter what financial product you are looking to invest in, there will always be a range of fees that you need to consider. In the world of index funds, this is identified by the fund expense ratio. Interestingly, the Securities and Exchange Commision (SEC) dictate that index funds must clearly stipulate the expense ratio of an index fund, subsequently allowing investors to make an informed decision on costings. Whilst the expense ratio is provided as a singular percentage, it is made up of multiple costs.
Ultimately, the expense ratio of an index fund will almost always be significantly lower than that of a managed mutual fund. One of the key reasons for this is that an index fund is passive, as opposed to active. In other words, as a S&P 500 index fund is based on the top 500 companies by market capitalization, index funds do not need to manage investor funds to the same degree of activity as seen in a managed fund.
On the contrary, managed funds need to utilize ample resources on portfolio management and active trading, which increase fees.
Whilst keeping your index fund expense ratio low is important, it should not be the only factor that you rely on when choosing the best S&P 500 fund. Other factors, such as liquidity, volume and growth potential, are also important.
So now that you know what an index fund expense ratio is, in the next part of our guide we are going to discuss three of the best S&P 500 index funds currently in the market.
Best S&P 500 Index Funds in the Marketplace
Here are 3 of the best funds you can invest in.
Vanguard 500 Index Fund
Vanguard are one of most established S&P 500 Index funds currently in operation. More than four decades ago, Vanguard founder John Bongle came to the conclusion that vary few investors were able to consistently outperform the bedrock of the S&P 500. As such, he came up with the concept of matching the top 500 companies like-for-like, with the view of keeping costs ultra-low.
The fund is managed by the Vanguard Equity Investment Group, which itself is owned by its investors. In terms of the expense ratio charged by Vanguard, the fund comes in at 0.04%. This is actually one of the most competitive in the market, especially when one considers to long-standing reputation of the Vanguard 500 index fund.
In order to achieve its goals, the team at Vanguard invest virtually all of their assets in to stocks of the top 500 U.S. companies, like-for-like with the official index.
Moreover, the fund will also distribute its holdings fully in-line with the same weightings as the index. At the time of writing, the Vanguard 500 Index Fund has $450.2 billion in assets. If you are a long-term investor and are looking to track the overall performance of the S&P 500 whilst still keeping costs low, then the Vanguard fund could be an attractive option.
SPDR S&P 500 ETF Trust
If one of your ultimate objectives is to find an S&P 500 index fund that offers high levels of liquidity and volume, then it might be worth considering the The Standard and Poor’s Depositary Receipts (SPDR) S&P 500 ETF Trust.
In a nutshell, this particular index fund is actually an ETF (Exchange Traded Fund). This means that the fund itself does not actually purchase, own or hold the stocks of the companies that constitute the S&P 500. Instead, the fund simply tracks the underlying prices, subsequently allowing investors to gain exposure to the performance of the S&P 500 with ease. This is different to the methods employed by Vanguard, who actually hold the stocks.
The SPDR is also different to the aforementioned index fund, insofar that it is technically classed as a Unit Investment Trust (UIT). In layman terms, this means that the SPDR index fund does not reinvest dividends into the portfolio and thus, investors are protected from having to pay capital gains tax. In terms of fees, the SPDR S&P 500 ETF Trust has an expense ratio of 0.09%.
If your overarching focus is primarily on maximizing gains, then it might be worth considering the iShares S&P 500 Growth ETF. This particular index adds a twist to its underlying mechanisms.
In order to maximum growth the iShares S&P 500 Growth ETF will increase its weightings to companies that are showing strong signs of growth.
To achieve these goals, the iShares S&P 500 Growth ETF will utilize three main factors. Notably, this consists of sales growth, earnings growth and momentum. However, it is important to note that by utilizing these specific factors, much of the focus will be on tech stocks.
Moreover, 34% of the index fund is held by just 10 companies. As such, this does add a higher element of risk in comparison to the likes of Vanguard. We should also note that the iShares S&P 500 Growth ETF is slightly more expensive than the previous two funds we have discussed, with an expense ratio of 0.18%.
To counter this, the iShares S&P 500 Growth ETF fund has outperformed the S&P 500 over the past 10 years, with gains of 15.45%.