Forget brand X: Try a better way to inxe

first_img AD Quality Auto 360p 720p 1080p Top articles1/5READ MORERose Parade grand marshal Rita Moreno talks New Year’s Day outfit and ‘West Side Story’ remake160Want local news?Sign up for the Localist and stay informed Something went wrong. Please try again.subscribeCongratulations! You’re all set! The king is dead. Long live the king. For many folks, indexing is pretty much synonymous with buying a Standard & Poor’s 500-stock index fund. Yet if you have a choice, I amnot sure there’s any reason to own an S&P 500 fund. Here’s why the king of i ndexing deserves to be toppled and what you should replace it with. Living Large Don’t get me wrong: I am not arguing that S&P 500 funds are a bad investment. Many fund companies and many 401(k) plans now offer these funds, and they are usually a low-cost, tax-efficient way of getting exposure to blue-chip U.S. companies. Moreover, fund performance has been impressive. Take the Vanguard 500 Index Fund (VFINX), the oldest of the S&P 500 funds and, at $108 billion in assets, the country’s second-largest mutual fund. (Only American Funds’ Growth Fund of America is larger.) The Vanguard fund’s popularity is richly deserved. According to Chicago investment researcher Morningstar Inc., it has outpaced 75% of the stock funds in the “large blend” category over 10 years. S&P 500 funds have also proven popular with buyers of exchangetraded index funds, the fast-growing funds that are listed on the stock market just like regular stocks. Standard & Poor’s Depositary Receipts which trade under the symbol SPY and are often referred to as “spiders” have $57 billion in assets, making them easily the largest of the ETFs. Double Trouble All that said, I don’t consider these funds the best choice for index- fund investors. What’s the problem? There are two. First, while the S&P 500 is clearly a key benchmark index for the U.S. market, it isn’t the entire market. With the S&P 500, what you get is exposure to 500 large-company stocks that together constitute almost 80% of the U.S. market. What about smaller U.S. companies? What about foreign stocks? If you buy just the S&P 500, you miss out on these two critical sectors, both of which have outperformed the S&P 500 in the past five years. Indeed, these days, I receive regular emails from investors who claim indexing is foolish because their investment picks have so easily beaten the S&P 500 in recent years. These folks are, of course, completely delusional. To beat the S&P 500 over the past five years, all you had to do was have a little money in bonds, or foreign stocks, or smaller companies. That doesn’t mean you picked market-beating investments. Rather, it means your portfolio doesn’t look like the S&P 500 and thus, if you compare your portfolio to that index, you’re making an apples- to-oranges comparison. There is a second, less obvious problem with the S&P 500. While the S&P 500 has had relatively low turnover and proven to be fairly tax-efficient, it’s hardly ideal. On average, over the past 10 calendar years, 32 new companies a year have been added to the index, as the folks at Standard & Poor’s, a unit of McGraw-Hill, tweaked the index or replaced companies that had been taken over or gone into bankruptcy proceedings. The trading costs involved, while modest, would have put a small dent in investors’ returns. Total Answer I asked John Bogle, founder of Vanguard Group in Malvern, Pa., about these issues. He is hardly a disinterested observer. Mr. Bogle was the driving force behind the 1976 launch of Vanguard’s S&P 500 index fund and, no doubt, has a soft spot for the fund. Still, he says that if you want to mimic the U.S. stock market, you should probably skip S&P 500 funds and instead purchase a “total- market” index fund that tracks all U.S. stocks, both large and small. Not only do these funds give you broader exposure, but also you should incur lower trading costs, because there won’t be big companies regularly moving in and out of the fund. These total-market funds mimic indexes such as the Russell 3000 and the Dow Jones Wilshire 5000. “Should the S&P 500 be supplanted by the total-stock-market index?” Mr. Bogle asks. “If you were starting today, you would want to start with the total-stockmarket index.” On the other hand, if you already own an S&P 500 fund in a taxable account and you have large unrealized capital gains, Mr. Bogle wouldn’t advise selling. “It would be absurd to get out of it,” he says. “I don’t think a rational investor would do that. The S&P 500 is a very good market standard. Over a 10-year period, the odds are that its returns will be similar to the total-stock-market index.” So should the total-stock-market index fund be crowned the new king of indexing? Not quite. Remember, U.S. stocks represent just half of world stock-market value. Crowning Moments My contention: There should be two new kings of indexing. Indeed, I believe anybody building a stock portfolio should start with two index funds: a U.S. total-market fund and a broadly diversified foreignstock fund. For instance, you might combine Fidelity Spartan Total Market Index Fund (FSTMX) with Fidelity Spartan International Index Fund (FSIIX), or Vanguard Total Stock Market Index Fund (VTSMX) with Vanguard Developed Markets Index Fund (VDMIX), or iShares Russell 3000 Index Fund (IWV) with iShares MSCI EAFE Index Fund (EFA). The iShares funds are exchange- traded index funds. To build a globally diversified stock portfolio, put 70% of your stock portfolio in the total-market fund and 30% in the foreign-stock fund. What if you are a little more adventurous? You could use these two funds as your core holdings, but slice off a few dollars and invest them in more specialized index funds. For instance, you might trim your foreign-stock index fund from 30% to 25%, so you can have a 5% stake in an emerging-markets index fund. Similarly, you might take your total-market fund down from 70% to 60% and then stash 5% in a smallcompany value index fund and 5% in a real-estate investment trust index fund. But these additional funds, while they might reduce risk and boost returns, shouldn’t be anything more than minor holdings. Instead, your two biggest stockfund holdings should always be your total-market-index fund and your total-international fund. Long may they reign.last_img read more