When it comes to selecting funds within their 401(k) or IRA plans, most Americans allocate a bulk of their nest eggs to stocks. More and more Americans are investing in stocks using equity index funds. By 2013, index funds had an 18.4% share of all stock fund assets, up from 9.5% in 2000.
And owners of all types of investment accounts are increasing their holdings on index funds for good reasons: broad market exposure, low operating expense, and low portfolio turnover. However, most retirement savers are only familiar with large-blend equity index funds. In reality, individual investors have a wealth of available index funds offering investments in medium and small cap U.S. companies, bonds, international stocks, and real estate. If you’re looking to learn more about the many options you have when it comes to index funds, this is for you!
U.S. small- and mid-cap index funds
Who they’re good for: Index funds investing in small- and mid-cap American companies allow you to diversify your investment in companies that have smaller balance sheets than more established companies and are more exposed to business cycles. By using an U.S. small- and mid-cap index fund as part of a well-diversified portfolio, you can increase your exposure to and potential gains in the U.S. market during periods of expansion.
Besides tracking the components of the S&P 500, index funds can also track the components of other benchmarks, such as the CRSP US Small Cap Index (a broadly diversified index of stocks of small U.S. companies) and the CRSP US Mid Cap Index (a broadly diversified index of stocks of mid-size U.S. companies).
Nobel prize winner in Economics Paul Samuelson said it best, “Forsake search for needles that are so very small in haystacks that are so very large”. These type of index funds do the homework that would take you too long to do on your own.
Here are some examples of these type of index funds:
| Fund Name | Annual Expense Ratio | Minimum Investment | 3-year Average Annual Performance |
|---|---|---|---|
| Vanguard Small-Cap Index Fund Investor Shares (NAESX) | 0.20% | $3,000 | 8.79%* |
| Vanguard Small-Cap Growth Index Fund Investor Shares (VISGX) | 0.20% | $3,000 | 7.28%* |
| Vanguard Small-Cap Value Index Fund (VISVX) | 0.20% | $3,000 | 10.04%* |
| Vanguard Mid-Cap Index Fund Investor Shares (VIMSX) | 0.20% | $3,000 | 10.62%* |
| Vanguard Mid-Cap Growth Index Fund Investor Shares (VMGIX) | 0.20% | $3,000 | 10.02%* |
| Vanguard Mid-Cap Value Index Fund Investor Shares (VMVIX) | 0.20% | $3,000 | 11.11%* |
*As of 9/23/2016
When selecting an index focusing on small- or mid-cap companies make sure to double check for its investing strategy. While a standard index fund focuses on provide a exposure to a broad range of companies, a growth index fund focuses on growth-oriented companies that tend to grow more quickly than their peers. On the other hand, a value index fund focuses on companies that may be temporarily undervalued by investors.
International stock index funds
Who they’re for: If you have a higher tolerance to risk or are many decades away from retirement, you could leverage an international stock index fund to gain equity exposure to foreign economies at a low cost. A main advantage of using an international index fund over buying the shares of an international company on your own is that you’re less likely to face low liquidity issues.
Here are some examples of index funds focusing on international markets:
| Fund Name | Annual Expense Ratio | Minimum Investment | 3-year Average Annual Performance |
|---|---|---|---|
| Vanguard Total International Stock Index Fund Investor Shares (VGTSX) | 0.19% | $3,000 | 1.93%* |
| Vanguard Developed Markets Index Fund Admiral Shares (VTMGX) | 0.09% | $10,000 | 2.74%* |
| Vanguard Emerging Markets Stock Index Fund Investor Shares (VEIEX) | 0.33% | $3,000 | -0.93%* |
*As of 09/23/2016
Keep in mind that international index funds can focus on different types of economies. Most investment firms focus on developed markets (e.g. Germany and England), emerging markets (less developed markets, including Brazil, Russia, India, and China), and frontier markets (markets experienced accelerated growth that they may become emerging markets, such as Argentina, Nigeria, and Sri Lanka). Most investment firms follow the MSCI market classification but often decide to include or exclude nations depending on the firm’s investment strategy.
Additionally, some index funds may focus on a single foreign stock market or track small-, mid-, or large-cap equities across several markets.
Bond index funds
Who they’re for: Besides being useful to diversify your portfolio, a bond index fund is also useful to gradually switch from a growth to an income strategy as you get closer to retirement age. If you’re holding to a target-date fund, it’s doing pretty much that. Instead of paying the often higher fees of a target-fund and settling for a one-size-fits-all investment approach that may not be suitable for your unique situation, you could increase your allocation to fixed-income securities on your own with a bond index fund. To help you decide whether or not target-date funds should part of your portfolio, review: Target Date Funds in 401(k) Plans: Good or Bad Idea?
In his 2013 letter to Berkshire Hathaway shareholders, Warren Buffett indicated that his will laid out the following instructions: “Put 10% of the cash in short-term government bonds and 90% in a very low-cost S&P 500 index fund. (I suggest Vanguard)”. Since The Oracle of Omaha is a big fan of low-cost index funds, he probably wouldn’t mind to also use an index fund to gain broad exposure to U.S. investment-grade government and corporate bonds with maturities from one to five years
Some bond index funds can also provide you exposure to intermediate-term and long-term domestic bonds at a low cost. Other bonds index funds provide you exposure to the domestic bond market as a whole through holdings in U.S. government and corporate bonds of all maturities.
Here are some examples of index funds focusing on bonds with different maturities:
| Fund Name | Annual Expense Ratio | Minimum Investment | 3-year Average Annual Performance |
|---|---|---|---|
| Vanguard Total Bond Market Index Fund Investor Shares (VBMFX) | 0.16% | $3,000 | 3.91%* |
| Vanguard Short-Term Bond Index Fund Investor Shares (VBISX) | 0.16% | $3,000 | 1.72%* |
| Vanguard Intermediate-Term Bond Index Fund Investor Shares (VBIIX) | 0.16% | $3,000 | 4.98%** |
| Vanguard Long-Term Bond Index Fund (VBLTX) | 0.16% | $3,000 | 9.24%** |
| Vanguard Short-Term Inflation-Protected Securities Index Fund Investor Shares (VTIPX) | 0.17% | $3,000 | 0.46%* |
| Vanguard Total International Bond Index Fund Investor Shares (VTIBX) | 0.17% | $3,000 | 5.62%** |
*As of 09/23/2016
**As of 06/30/2016
Just like with stocks, bond index funds can also provide exposure to international markets. While international bond index funds use hedging strategies against uncertainty in future exchange rates, keep an eye on the credit quality of bonds included in the portfolio.
If a bond index fund includes money market funds among its holdings, make sure to read about the October 2016 SEC Changes to Money Market Investments.
Real estate index funds
Who they’re for: While most individual investors may afford to buy one property or stake in a real estate investment trust at a time, all individual investors could leverage a real estate index fund to gain returns from several real estate investment trusts.
On the previous list of bond index funds, you may have spotted one that aims to generate returns closely correlated with inflation. However, another way to hedge against inflation is to seek real estate income.
Depending on your tolerance to risk, time left until retirement, and your level of concern about the future of inflation, most financial advisers would recommend you to allocate from 5% to 20% of your portfolio to a real estate index fund. Allocating less than 5% may not work as a shield against inflation and allocating beyond 20% leaves you to exposed to the high volatility of some real estate markets.
Here is an example of a real estate index fund:
| Fund Name | Annual Expense Ratio | Minimum Investment | 3-year Average Annual Performance |
|---|---|---|---|
| Vanguard REIT Index Fund Investor Shares (VGSIX) | 0.26% | $3,000 | 13.25%* |
*As of 09/23/2016
The bottom line: Review all of your index fund options
If your plan doesn’t offer you access to index funds or just limits you to a very few, consider Human Interest, which includes low-cost Vanguard index funds from every major asset class and risk category. With Human Interest, you can have access to Vanguard funds in the Admiral share class without any minimum account balance on your part (generally, you would need $100,000 for them). All Admiral class funds have lower annual expense ratios than their investor class counterparts. For example, the Vanguard Small-Cap Index Fund Admiral Shares (VSMAX) has a 0.05% annual expense ratio, which is lower than the investor shares version.
Take the time to carefully review all the investment options available through your 401(k). Depending on your retirement saving strategy, tolerance to risk, and unique financial situation, you may benefit from an investment in index funds in small- and mid-cap domestic equities, foreign equities, bond markets, or real estate investment trusts.
Photo credit: Olu Elet
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Article By
Damian DavilaDamian Davila is a Honolulu-based writer with an MBA from the University of Hawaii. He enjoys helping people save money and writes about retirement, taxes, debt, and more.
