If you want your portfolio's value to grow with the U.S. economy and don't want to choose individual stocks, an S&P 500 index fund could be a smart choice. In fact, legendary investor Warren Buffett has said that investing in low-cost S&P 500 index funds is a bet on the future of U.S. economic growth and the best way for most people to build wealth.
What are S&P 500 index funds and why are they popular?
An index fund is designed to mirror the performance of a stock index. An S&P 500 index fund invests in each of the 500 companies in the S&P 500 (SNPINDEX: ^GSPC). It doesn't try to outperform the index; instead, it uses the index as its benchmark and aims to replicate its performance as closely as possible.
S&P 500 funds are by far the most popular type of index fund. But index funds can be based on practically any financial market, investing strategy, or stock market sector.
Index funds are popular with investors for a number of reasons. They offer easy portfolio diversification, with some funds enabling portfolio exposure to hundreds or even thousands of stocks and bonds. You don't risk losing all your money if one company performs poorly or collapses as you would with individual investments. However, you also don't get exposure to the potentially astronomical returns that can result from picking a single huge winner.
Index funds are passively managed, which means you're not paying for someone to actively pick and choose investments. This results in a lower expense ratio from lower investment management fees compared to actively managed funds.
- Your money will track the market's performance. Historically, the S&P 500's annual returns have been in the 9% to 10% range. Some years, the index will lose value, of course. During the Great Recession, the S&P 500 lost about half of its value. As of May 10, 2022, the S&P 500 was down more than 20% for the year to date. But over the long term, it's always recovered. Never in the S&P 500's history has a 20-year investment resulted in a loss.
- You keep more of your investment profits in your pocket. Buffett's case for low-cost S&P 500 index funds centers on their low fees. While active managers are likely to match the market's performance over time, their fees eat away at your returns. Buffett famously won a $1 million bet against investment manager Ted Seides that a low-cost S&P 500 index fund could beat a hand-selected hedge fund portfolio over 10 years.
- You're investing in 500 of the most profitable companies in the U.S. The corporations represented in the S&P 500 are subject to stringent listing criteria. To join the index, a company must have an $11.8 billion market capitalization, and the sum of its past four quarters' earnings must be positive. Each company must also get approval from an index committee. The S&P 500's largest holdings include Apple (NASDAQ:AAPL), Amazon (NASDAQ:AMZN), Microsoft (NASDAQ:MSFT), and Johnson & Johnson (NYSE:JNJ).
- You can put your investment decisions on autopilot. The S&P 500 has a flawless track record of delivering profits over long holding periods, so you can invest without worrying about stock market fluctuations or having to research individual companies. You can simply budget a certain amount and automatically invest it on a regular schedule. This practice is known as dollar-cost averaging. Even if you do pick individual stocks, S&P 500 funds are a good foundation for your investment portfolio since you're guaranteed the returns of the stock market.
3 best S&P 500 index funds
These three major S&P 500 funds are extremely similar in composition since each tracks the performance of the same index:
- Vanguard S&P 500 ETF (NYSEMKT:VOO)
- iShares Core S&P 500 ETF (NYSEMKT:IVV)
- SPDR S&P 500 ETF Trust (NYSEMKT:SPY)
All three exchange-traded funds (ETFs) -- a type of index fund -- invest in the 500 companies that make up the S&P 500 index. Each has very closely replicated the index's performance:
| Fund Name | Expense Ratio | Total Fund Assets |
|---|---|---|
| Vanguard S&P 500 ETF | 0.03% | $806.5 billion |
| iShares Core S&P 500 ETF | 0.03% | $292.7 billion |
| SPDR S&P 500 ETF Trust | 0.0945% | $371 billion |
There are negligible differences between the performances of the S&P 500 index and each of these three funds that track it. The S&P 500 outperformed each fund slightly, as would be expected when accounting for each fund's expense ratio.
At the S&P 500's rate of return, a $10,000 investment made in early 2017 would have grown to $23,340 by the end of 2021. As the table below shows, even the worst-performing index fund of the three would have increased that $10,000 investment to $23,230 over the same five-year period.
| Index or Fund | 1-Year Total Return | 3-Year Annualized Return | 5-Year Annualized Return |
|---|---|---|---|
| S&P 500 Index | 31.46% | 26.29% | 18.63% |
| Vanguard S&P 500 ETF | 31.35% | 26.24% | 18.54% |
| iShares Core S&P 500 ETF | 31.33% | 26.24% | 18.54% |
| SPDR S&P 500 ETF Trust | 31.28% | 18.04% | 18.49% |
With any of these three funds, you can expect your investment to deliver performance that's virtually identical to the S&P 500. The Vanguard and iShares options have the lowest expense ratios. However, if you're a fan of SPDR products, a 0.0945% expense ratio isn't high by any means. A 0.0945% expense ratio means that $9.45 of every $10,000 invested is annually collected as a management fee.
One thing to be aware of is that, like the S&P 500 index, all three funds listed above are weighted by market capitalization. That means that your investment is heavily concentrated in the biggest companies. In each of the three top S&P 500 index funds, the top 10 companies represent about 30% of its holdings.
If you want to invest in the quality large-cap companies in the S&P 500 while spreading out your risk a bit more, you could opt for the Invesco S&P 500 Equal Weight ETF (NYSEMKT:RSP). Because it's an equal-weighted fund, it aims to invest the same dollar amount in each of the S&P 500 stocks. As a result, you'd expect the top 10 holdings to account for just 2.5% at any given time.
Beware of leveraged S&P 500 index funds
Be wary of leveraged funds that are advertised as S&P 500 ETFs. Leveraged ETFs use borrowed money and/or derivative securities to amplify investment returns or to bet against the index. For example, a 2x-leveraged S&P 500 ETF aims to return twice the index's performance each day. So if the index rises by 2%, the ETF's value rises by 4%. If the index falls by 3%, the ETF loses 6%.
These leveraged products are intended to be day-trading instruments and have an inherent downside bias over the long term. In other words, a 2x-leveraged S&P 500 ETF, over the long term, will not return twice the index's performance.
Investing in S&P 500 index funds is one of the safest ways to build wealth over time. But leveraged ETFs, even those that track the S&P 500, are highly risky and don't belong in a long-term portfolio.
