How To Invest Using Index Funds
March 6, 2014
“My ideas are very simple. In investing, you get what you don’t pay for. Costs matter. So intelligent investors will use low-cost index funds to build a diversified portfolio of stocks and bonds, and they will stay the course. And they won’t be foolish enough to think that they can consistently outsmart the market.” – John Bogle, Founder of Vanguard
While not completely necessary, it would be helpful for readers of this lesson to first read and understand the previous lessons on this site:
This lesson is designed to demonstrate easily implemented, low cost solutions for retirement investing. Currently, there are no index funds which employ a moral screen. So, they are appropriate only for investors who feel no need to exclude certain stocks from their portfolio based on moral criteria (for a summary of the various issues surrounding different types of investment vehicles and strategies, please check out the introduction to our Christian investing website). If you're looking for extreme ease of use, the rational expectation of solid returns over long periods, and have no concerns about issues of morality in investing, you should strongly consider index funds as your best option for making investments.
Index funds are a type of mutual fund. They give investors exposure to passive portfolios that are modeled after market indexes (fun fact: indices is also a correct plural form of index), such as the S&P 500. They result in extremely low cost, well-diversified portfolios that are easily accessed by individual investors. There can be long periods over which the broad market doesn't perform all that well. But overall, the market indexes have done well historically. The average annual return from 1928 - 2013 was 9.55% . By the way, I am referring to the geometric average annual return. The arithmetic average goes beyond useless, into the realm of misleading information (in regard to developing an expectation for future average returns).
Back to the topic at hand, investors don’t need a financial advisor to sell them index funds. They don’t need a certain amount of money. Pretty much anyone can get started today investing in index funds, through one form or another.
Target Retirement Funds
The first method I want to highlight, is to use Vanguard Target Retirement Funds. These funds are basically an out of the box solution for retirement investors. You can simply choose the fund that best corresponds to your target retirement date, and start putting money into it. However, you do need $1,000 to get started with Vanguard Target Retirement Funds. Other Vanguard Mutual Funds typically have a $3,000 minimum to get started (Vanguard ETFs have no minimum).
Vanguard Target Retirement Funds have an average expense ratio of .17%. By comparison, the average actively managed mutual fund (including both equity, bond, and mixed funds) is 1.26%, according to Morningstar. On top of that, consider that the Target Retirement Funds make asset allocation decisions for you, based on your target retirement date. That is a huge part of what financial advisors do, and precisely how many of them claim to add value. Yet, they typically charge at least 1% annually to do it. Further, they typically place clients in much more expensive investment products. So, instead of going to an advisor and paying a total of 2-3% in annual fees, you can get the same basic service for .17% annually, resulting easily in hundreds of thousands, or even millions of dollars more over a lifetime of investing (depending on how long you invest and in what amounts).
Once you save up $1,000, you can open an IRA, Roth IRA, or other type of account with Vanguard. Then you fund the account. Then you can set up automatic deductions from your checking account each month, which can be directed into the Target Retirement fund of your choice. You don’t have to, but the whole process can be completely automated. If you want to do the right thing with your money, but never have to concern yourself with investment related topics or stress, this is a great “set it and forget it” approach. Just set your contributions on autopilot, increase your contributions as much as possible going forward, and retire with a huge nest egg (if you start early!).
If you’re wondering how much you need to invest in order to achieve your goals, Vanguard has great tools to help you with that. Of course, you can also call them up at any time with questions you may have about your specific situation. They have always come across as very knowledgeable, friendly, and helpful with me. The great thing about calling Vanguard, is that none of their employees are driven by commission or other profit motives. You can immediately tell the difference when you call a representative that is paid a fixed amount to help people, as opposed to a person trying to sell you whatever results in the most commissions for him or herself.
One last item of note about their service: once you have a large enough portfolio (currently $500,000 or more) with Vanguard, you get free access to a Certified Financial Planner. Those planners, like all Vanguard employees, are paid a salary by Vanguard. There is no commission or fee structure for Vanguard Financial Planners, which results in unbiased financial planning services.
Here's a quick recap of the steps required to implement this solution:
1) Save $1,000
2) Choose the type of account you want to open (IRA, Roth IRA, or other). Click on this link: Open the account.
3) Fund the account. Typically this is done by sending a check or through a direct debit of your checking account.
4) Choose the target date retirement fund that best corresponds to your expected retirement goal.
5) Set up automatic debits from your checking account in order to regularly contribute to the account. Contribute as much as you can possibly afford, but be aware of annual limits on IRAs.
6) Set up your contributions to go automatically into the Vanguard Target Retirement fund that you chose.
7) Retire (many years later!).
Vanguard representatives are readily available to walk you through any or all of these steps.
Vanguard ETFs have two distinct advantages over Vanguard Target Retirement Funds:
1) You can tailor asset allocation decisions according to your own views, plan, etc.
2) Some of them have significantly lower fees (though the Target Retirement Funds have low fees as compared to the average for similar products)
First, let me give an example of what I mean about tailoring asset allocation decisions. Vanguard TR Funds undoubtedly are based on some serious analysis and study. However, my personal view is that they stay too heavily focused on equities for too long. If you’ve read my lesson on asset allocation, you know that I like 0-25% as a target range for equities, once you’re in retirement. That’s because if you’ve invested properly over your lifetime, you won’t need very much exposure to equities once you reach retirement age. You can have better peace of mind with a retirement portfolio that is largely built of long term corporate bonds.
By contrast, Vanguard TR Funds currently follow a path that leads to a 50% equity, 50% fixed income allocation upon the target retirement date. Then, they continue to reduce the equity exposure over the first 10 years of retirement, until it levels out at a perpetual 30% allocation to stocks thereafter.
Obviously, I’m a little more conservative. I think meeting your investing goals should be accomplished more by increasing your monthly or annual contributions as much as possible during your working years, as opposed to taking increased risk in your retirement years. But, everyone’s situation is different.
If I were going to build a portfolio of ETFs, it would follow my broad asset allocation ranges. For example, if I were 30 years away from retirement, my portfolio would hold 90-100% equity and 0-10% fixed income. Because stocks are highly valued at the moment (sporting a Shiller PE of 25.92 on the day of publication), I would probably incorporate my view by holding a 10% allocation to fixed income. However, because bond yields aren’t all that attractive either, I would probably not have the 10% allocation in long maturity bonds. Instead, I would have them in what is referred to as intermediate duration bonds. So, this is what my Vanguard ETF portfolio would look like with 30-40 years until retirement:
The reasoning behind these particular choices and weightings is beyond the scope of this particular lesson. I will address the question of how to allocate equity investments among various categories in depth, in an upcoming lesson entitled How To Manage Your Stock Portfolio. After that lesson is finished and posted, I will start working on one that applies the information from it to ETFs, in a lesson entitled How To Build A Portfolio Of Index ETFs. For this particular lesson, I simply wanted to introduce the idea, and demonstrate how easy (and low cost) it is to build a portfolio of index ETFs.
As far as ease, you would have to actually make your trades each month since ETFs are traded on exchanges (they are still commission free through Vanguard). Vanguard can take automatic deductions from your checking account each month, in order to fund your account, and then automatically put them into any of their mutual funds (that you choose in advance). But they can't automatically invest your contributions into ETFs. You can still make automatic contributions, but you would have to login to your account to execute the trades. But it’s extremely easy to do that. It would take less than 5 minutes each month. So, building a portfolio of index ETFs is a little less autopilot than using Vanguard Target Retirement Funds. But the good news is that there are no account minimums. ETFs trade in whole shares (no fractional shares), so the only minimums would be dictated by the share prices themselves.
To the point about expenses, Vanguard mutual funds and ETFs can both be purchased and sold through Vanguard for zero commission. But, they do have ongoing expenses built into them. Some of the ETFs have much lower expenses than the .17% average expense ratio for Vanguard Target Retirement Funds. For example, VOO, The Vanguard S&P 500 ETF, currently has an expense ratio of .05%. In case you’re wondering how Vanguard compares to similar products put out by other firms, they generally are much lower. In the case of iShares (probably the largest ETF competitor), their S&P 500 ETF has an expense ratio of .07%, which isn’t all that much different from Vanguard (.05%). But in the case of high expense categories such as emerging markets stocks, there can be a huge difference. The Vanguard EM ETF has an expense ratio of .15% versus iShares EM ETF at .67%. Whoa.
While it generally pays to shop around, the fact is, it’s pretty tough for anyone to beat Vanguard. That’s because they don’t operate to generate a profit (more about that in the note below).* Their expense ratio is based on their costs, which they work hard to keep as low as possible. Their expense ratios drop as they gather more assets under management.
I know this lesson sounds a little like a giant advertisement for Vanguard. But, what you’ve gotten is a completely unbiased perspective based on fairly extensive knowledge of the investment industry and its practices. I have no business relationship whatsoever with Vanguard. I receive no benefits or payments from them to cover their products. I’m just trying to help readers make wise decisions with their money. So, just like I’ve always told friends and family who ask me to look at their 401K or other accounts, “It’s tough to go wrong with Vanguard.” That’s my honest opinion. I hope you find it helpful. Thank you so much for reading!
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*NOTE: By the way, if you’re wondering why Vanguard is so wonderful, you can click on this link to find out more about Vanguard’s history and structure. The short answer is that Vanguard was founded as a non-profit organization, is owned by its fund investors, and designed to put clients’ interests first, second, and third.
If you know very much about the history of the financial industry, you’ll understand why I sound like I’m getting misty-eyed when I talk about Vanguard. I wish I had the money or backing to start a Christian version of Vanguard that offered low cost, passive, morally screened investment products, but I don’t. I don’t mean to imply that Vanguard is somehow non-Christian (I’m sure they have Christians working there) or anti-Christian, just that they aren’t an explicitly faith-based or Christian organization. Interestingly, the founder has publicly expressed Christian beliefs in the past.
Disclosure: At the time of publication, the author does not hold any positions in any of the securities mentioned and has no plans to initiate positions in those securities within the next 72 hours. The views expressed are the opinions of the author and do not necessarily reflect those of Wisdom’s Reward, LLC.