If you guess that the best S&P 500 Index funds are those that have the lowest Expense Ratios, you are mostly correct. However, in addition to low costs, there is a delicate balance of science and art to indexing that makes only a few mutual fund companies able to offer the best index funds.
What Makes the Best Index Funds
- Keeping Costs Low: This is the aspect of index fund investing that most investors know to be crucial to produce the best index funds. Essentially, the index funds with the lowest expense ratios generate the best returns over time. This is also an advantage of using index funds as opposed to actively-managed funds. For example, if an index fund has an expense ratio of 0.12 but a comparable actively-managed fund has an expense ratio of 1.12, the index fund has an immediate 1.00% advantage over the actively managed fund. Because index funds are passively managed (they simply match the holdings of a given index), the costs of managing the fund are dramatically reduced. With no real research required, costs can be kept extremely low, which has a positive impact on returns over time.
- Matching Index Fund Holdings (Index Tracking): Now we are getting into the science of indexing. Investment analysts put together indexes (various lists of stocks or bonds) to create benchmarks for the purpose of measuring broad market averages. The best known indexes are the Dow Jones Industrial Average, The S&P 500 and the NASDAQ. Index funds seek to mirror the performance of a particular benchmark index. For example, most large-cap stock funds try to beat the best-fit index for large-cap stocks, the S&P 500. However, the objective of an S&P 500 Index fund is not to "beat the index" but to match it, which means the fund will attempt to replicate the performance of the index. To do this, put simply, the fund will hold the same stocks found within the S&P 500. Therefore, the best stock index funds will do a good job of matching the list of stocks (holdings) represented in the benchmark index. Stock analysts my call this "low tracking error."
- Using Proper Weighting Methods: There is more to building an index fund than simply buying the securities represented in the index. To create an index fund, and insure good performance tracking, the management team and supporting staff will determine how much (the number of shares) of each holding on the list to purchase. The idea is to match the percentage "weighting" of the index itself. Indexes that rank the holdings so that the larger components are given larger percentage weights are called capitalization-weighted indexes (aka cap-weighted or market cap weighted indexes). The S&P 500 is an example of a cap-weighted index. Most index funds will mirror the cap-weighted index by buying shares of holdings to make the stocks with the largest capitalization the largest holding by percentage in the index fund. For example, if XYZ Corporation stock has the largest market capitalization, XYZ Corporation stock will represent the largest percentage of the index fund.
- Sizing Things Up: In the indexing world, size can matter. Large mutual fund companies, such as Vanguard, Fidelity and Charles Schwab have large numbers of investors and therefore they have the assets to effectively manage the fund (i.e. buy shares of holdings, provide liquidity to meet demand for investor withdrawals). By comparison, an index fund with a low amount of assets may find difficulty in keeping the portfolio properly weighted to the index.
The Best S&P 500 Index Funds
Now that you know what it takes to make the best index funds, you can now move on to selecting the best S&P 500 Index Funds. I'm sure you'll agree with our top three S&P 500 Index Fund selections:
- Vanguard 500 Index (VFINX): Vanguard was built upon indexing and is the original in the world of index funds. More than 35 years ago, Vanguard founder, John Bogle, observed that the majority of stock investors were unable to outperform the S&P 500 Index consistently over long periods of time. His idea was to simply match the holdings of the index and keep costs low. Simplicity and frugality are two of the greatest tenets of successful investing and Vanguard has these virtues mastered. Vanguard is also owned by its investors, which places its priorities on providing high-quality, low-cost mutual funds and ETFs, as opposed to a culture of high profits typical of some publicly-owned financial institutions.
- Fidelity Spartan 500 Index (FUSEX): Fidelity's size, experience with indexing and desire to compete with Vanguard combine to make their index fund offerings second only to Vanguard's. Often the index funds between the two giant rivals are indistinguishable in terms of expenses and performance. Ultimately, the competition creates higher quality funds for the investor.
- Schwab S&P 500 Index(SWPPX): Charles Schwab has made a conscious effort to provide more than just discount brokerage service to investors: They have dipped deeply into the index fund markets of Vanguard and Fidelity. Their index funds are usually a bit higher in expense ratio than their larger competitors but if you are already a Schwab investor, you may as well save the transaction fee for using out-of-network funds and use the Schwab index funds.
Tips for S&P 500 Index Fund Research: If you are fortunate enough to have high balances in your investment accounts, you may qualify for other share classes that have even lower expense ratios than those funds listed here. For example Vanguard has another share class, called Admiral Shares that provide lower expense ratios. The Vanguard 500 Index Admiral (VFIAX) has an expense ratio of only 0.06, whereas VFINX has an expense ratio of 0.17%.
Disclaimer: The information on this site is provided for discussion purposes only, and should not be misconstrued as investment advice. Under no circumstances does this information represent a recommendation to buy or sell securities.