“Don’t look for the needle in the haystack. Just buy the haystack!“
– Burton Malkiel
- What is a Random Walk?
- The Difference Between Index Funds and Exchange Traded Funds (ETFs)
- Fidelity ZERO Large Cap Index Fund (NYSE: FNILX)
- Vanguard Total Stock Market Index Fund (NYSE: VTI)
- SPDR Portfolio S&P 500 High Dividend ETF (NYSE: SPYD)
One of my favorite investing books is “A Random Walk Down Wall Street,” a groundbreaking tome about passive investing in index funds. That may not sound revolutionary now, but it was an unheard-of strategy when it came out 50 years ago.
That's because index funds didn't even exist until 1976 when legendary investor Jack Bogle created The Vanguard S&P 500 Index Investor Fund (NYSE: VFINX), which was the first fund that simply tracked the S&P 500.
He was laughed at and scorned by his peers, some of whom shouted that the very idea was “un-American.” They called it “Bogel's folly.” Why would any investor accept average returns?
Because it works over time, that's why.
The Vanguard S&P 500 Fund started with $11 million in assets and has grown to over $792 billion today. If you had invested in The Vanguard S&P 500 Index Investor Fund upon inception, you'd be sitting on approximately 9,865% gains.
Who's laughing now?
*Editor's note: As of 2010, The Vanguard S&P 500 Index Investor Fund is now known as Vanguard 500 Index Fund (NYSE: VOO).
What is a Random Walk?
“Random Walk” author Burton Malkiel first described his random walk theory by writing that “prior stock prices are not good predictors of future prices. Instead, stock prices behave in an unpredictable manner. Thus, an investor should not rely upon the trend of prior stock prices to predict future stock prices. A logical outcome of this theory is that a financial advisor will not be able to outperform the market, and so is not worth the fees charged.”
Simply put, investors are merely taking a random walk alongside the unpredictable stock market, and trying to pick stocks is a fool's errand. According to Malkiel, you should bet on the entire market over the long run.
Malkiel also goes on to state that every investor technically has all the information needed to identify stocks simultaneously, so nobody has an edge over anyone else. He also points out that most active fund managers fail to beat the market in most years.
His theory checks out: if you invested $10,000 in the Vanguard S&P 500 Index Investor Fund (NYSE: VFINX) and held onto it from 1985 to 2022, you would have ended up with $181,440.
If you had reinvested those dividends, that payout would have been $514,017.
That's a heck of a return for a vehicle derided as having “average returns.”
While I agree that you should have the safe portion of your retirement portfolio in either indexes, ETFs, or dividend-paying blue chips, it's nice to take a swing at stock picking with your fun money. Malkiel actually agrees with me. In an interview with Kiplinger to celebrate the 50th anniversary of “Random Walk,” he admitted to buying stocks now and again.
“I enjoy gambling, and I enjoy buying individual stocks. But I can do it because my 401(k) plan is completely invested in index funds. So if you’ve got enough for a comfortable retirement all saved in index funds and you want to have fun and buy individual stocks, by all means, go and do it. I don’t think I do any better than average with the stock picks that I have. I do it because it’s fun.”
Every investor is different, and I have had a great deal of success in identifying individual stocks. Sure, I've struck out on some after falling victim to a stock's past performance or some unpredictable hype, but I've come out strong in the end.
However, I own several index funds and ETFs to help anchor the safe side of my portfolio.
Let's look at a few index funds and an ETF, but first, let's answer the question, “What's the difference?”
The Difference Between Index Funds and Exchange Traded Funds (ETFs)
This is a question I get a lot. Both vehicles attempt to do the same thing, track the market by investing in a broad range of stocks that track the S&P 500 or the NASDAQ composite.
While index funds focus on the broader stock market, ETFs often focus on specific areas of the market, like high-yield dividends, biotech stocks, or energy. If you have a sector you're bullish on, odds are you'll find an ETF that will suit your fancy.
So there are some key differences between them. Here's the side-by-side breakdown…
- Structure: ETFs are traded on stock exchanges like individual stocks, while index funds are mutual funds that are bought and sold at the end of the trading day at the net asset value price.
- Trading flexibility: ETFs can be bought and sold throughout the trading day, while index funds can only be bought or sold at the end of the trading day. This isn't a major concern for buy-and-hold investors, but ETFs allow the flexibility to sell whenever you'd like without waiting for the closing bell.
- Costs: ETFs generally have lower expense ratios than index funds because they do not require the same level of management and administrative costs. Many ETFs have expense ratios of 0.05%, which means on a $10,000 investment you'd only pay $5 a year in fees. Index funds are often higher than that.
- Minimum investment: ETFs can be purchased in single shares, while index funds often require a minimum initial investment. So if you want to start with $50 and slowly add to your position, ETFs are a better bet. You can also buy fractional ETF shares if you want to automatically dollar-cost-average your position with, for example, a $50 per month investment.
- Taxes: Because of their structure, ETFs may be more tax-efficient than index funds, as they typically generate fewer taxable events, such as capital gains distributions.
In the end, index funds and ETFs are low-cost options compared to most actively managed mutual funds. To decide between ETFs and index funds specifically, compare each fund's expense ratio, first and foremost, since that's an ongoing cost you'll pay the entire time you hold the investment.
Let's look at some of the most successful index funds and throw in an ETF for good measure.
Fidelity ZERO Large Cap Index Fund (NYSE: FNILX)
The Fidelity ZERO Large Cap Index Fund is attractive because – as the name suggests – it doesn't have an expense ratio at all.
It is a smaller index fund with $5.6 billion in assets versus the $792 billion in holdings for the Vanguard 500 Index Fund (NYSE: VOO). ZERO holds 80% of its assets in large-cap stocks, specifically the largest 500 U.S. companies based on market capitalization.
ZERO is heavy on tech (27%), financial services (13.44%), and healthcare (13.2%).
Here’s a look a their top 10 holdings:
- Microsoft (NASDAQ: MFST)
- Apple (NASDAQ: APPL)
- Amazon (NASDAQ: AMZN)
- Tesla (NASDAQ: TSLA)
- Alphabet Class A (NASDAQ: GOOGL)
- Alphabet Class C (NASDAQ: GOOG)
- Meta Class A (NASDAQ: META)
- NVIDIA Corp (NASDAQ: NVDA)
- Berkshire Hathaway Inc Class B (NYSE: BRK.B)
- JPMorgan Chase & Co (NYSE: JPM)
Here’s how the Vanguard 500 Index Fund (NYSE: VOO) looks since it started in mid-September 2018:
While 51% isn't bad, it is what I would call a very average return during the largest bull market in history. But ZERO did what it was supposed to do and tracked the market almost perfectly.
Fidelity ZERO Large Cap Index yields a notch under 1% for their dividend. As mentioned above, it's important to reinvest your dividends in any long-term index fund. Let's look at a similar – yet much larger – fund with a better dividend.
Vanguard Total Stock Market Index Fund (NYSE: VTI)
The Vanguard Total Stock Market Index Fund sports very similar holdings and returns as the Vanguard 500 Index Fund and Fidelity ZERO Large Cap Index fund, but there are a few crucial differences between them.
While those funds just track the S&P, VTI goes even further and counts smaller-cap stocks among its holdings. That's because VTI tracks the CRSP US Total Market Index. That index is well beyond the scope of the S&P 500 and covers nearly 4,000 equities across mega, large, small, and micro capitalizations, representing nearly 100% of the U.S. investable equity market. So while the other two indexes we mentioned only consider the market as the top 500 companies, VTI actually gives you complete market access.
All told, VTI has a whopping 3,945 holdings.
But is that a good thing? Let’s check out the returns for each of the indices we’ve discussed so far:
As you can tell, there hasn't been a huge difference in performance. But VTI stands out because it has a higher ceiling when smaller cap stocks outperform the broader market while still anchoring your position with the larger blue chips that dominate the S&P 500. In fact, VTI's top ten holdings are almost identical to VOO's.
VTI has a minuscule expense ratio of 0.03%, higher than ZERO but as low as you'll see among most index funds or ETFs. However, the dividend yields 1.56%, which far outweighs ZERO and will give you much greater returns over the long run if you reinvest those dividends.
Now that we've looked at two more traditional index funds, let's take a gander at a more specialized ETF that still plays on a broad swath of the market but one with much higher yields.
SPDR Portfolio S&P 500 High Dividend ETF (NYSE: SPYD)
The SPDR Portfolio S&P 500 High Dividend ETF is one of the highest-yielding ETFs that still focuses on the S&P 500. Where the last few index funds we discussed cast a broad net over the market, SPYD zeroes in on the highest-yielding S&P 500 stocks and some other high-yield companies, including real estate investment trusts or REITs.
It holds around 80 stocks at any given time.
You can see the vast difference in approach when you look at SPDR's top ten holdings:
You can see the vast difference in approach when you look at SPDR’s top ten holdings:
- Seagate Technology Holdings (NASDAQ: STX)
- ConocoPhillips (NYSE: COP)
- Iron Mountain Inc. (NYSE: IRM)
- Regency Centers Corp. (NASDAQ: REG)
- Simon Property Group Inc. (NYSE: SPG)
- Public Storage (NYSE: PSA)
- Exxon Mobil Corp (NYSE: XOM)
- Federal Realty Investment Trust (NYSE: FRT)
- Marathon Petroleum Corp. (NYSE: MPC)
- The Interpublic Group of Companies Inc (NYSE: IPG)
The first thing you'll notice is that, outside of Seagate, there is a complete lack of tech companies (which rarely pay dividends; if they do, the yields are very small). All of the above companies pay dividends of around 4% or more.
SPYD itself sports a 4.7% dividend – almost five times more than ZERO and three times more than VTI.
You might be asking: “What's the catch?” If they pay outsized dividends, the ETF itself probably didn't perform as well, right? You can't have it both ways, can you?
Indeed you can. Just look at SPYD over the last ten years:
I wouldn't call that an average return. I'd call it an excellent one. And those results don't even take the dividend into account. Sometimes expanding your options just beyond the safe confines of the S&P 500 can reward you handsomely without any undue risk.
There are hundreds of index funds and ETFs to choose from, so I hope this primer helps you identify a few worth buying and holding. When doing your own due diligence, remember to examine the track record against the S&P 500, the dividend yield, and the expense ratio. Then sift through the fund or ETF holdings to find one that aligns with your investing philosophy.
Even though I believe that the “Random Walk” theory is solid, I agree that you can get better-than-average returns without sacrificing too much safety.
In fact, I currently hold a position that has safely returned me triple digits, and I believe it will do so again over the coming year. It's a high-yielding, recession-proof stock that actually thrives when inflation is high. If you're not interested in finding a needle in a haystack, you don't have you. I've already done it for you.
You can read about the history of this mysterious company and get the ticker symbol right here.
Godspeed,
Jimmy Mengel
The Profit Sector
Follow me on Twitter @mengeled
