The Only 5 Index Funds You Need to Own

If you're not an investing hobbyist and you don't employ an adviser, you simply have no reason not to invest in index funds--funds that track broad market indexes rather than try to beat them.

But which index funds? Surprisingly, there's little information about building a diversified portfolio of good index funds and adjusting it as your goals change. Standard & Poor's 500-stock index is fine for tracking the performance of large U.S. companies, but it's not a complete portfolio.

This article will help you construct a simple but powerful package that also includes bonds and stocks of small companies, as well as foreign stocks. It's a long-term buy-and-hold portfolio, so I deliberately didn't fine-tune it to meet current market conditions.

You would have had to be living in a cave the past year to miss the clamor over index funds. Everyone from Warren Buffett to Dilbert has extolled their merits lately.

I don't believe, as some do, that index funds are the only sensible way to invest. But they are a sound method. Thanks primarily to their rock-bottom costs, index funds have outperformed roughly two-thirds of actively managed funds across all kinds of markets--and they'll almost surely continue to do so. What's more, picking the one-third of funds that will beat their indexes is exceedingly difficult; many argue that it's impossible.

How to build an index portfolio? To start with, stick to Vanguard-sponsored mutual funds and exchange-traded funds. Vanguard practically invented index funds and has decades of experience running them--virtually without a hiccup. Don't kid yourself: It takes real expertise to manage an index fund well, which means coming as close as humanly possible to matching the return of the underlying index.

More importantly, Vanguard funds are frequently, though not always, the cheapest. When you're buying funds that seek to track broad market indexes, there's simply no excuse for overpaying due to high expenses.

The Vanguard cost advantage comes about because Vanguard isn't a for-profit company; it has no shareholders who want dividends. Blackrock or Schwab may offer some funds or ETFs at slightly lower prices--but over time, I expect those prices to rise.

Below are the only index funds or ETFs you need to achieve your goals. Choose ETFs or conventional funds depending on what works best for you; if expenses are equal, there should be essentially no difference in performance between a mutual fund and an ETF that tracks the same index. All the indexes are weighted by their holdings' market values--in other words, the most popular securities get much bigger weightings. For each fund, I list the symbol for the mutual fund version first and then for the ETF. The mutual fund symbols are for Vanguard's admiral shares, which require a minimum investment of $10,000. You can buy into Vanguard's Investor share class for as little as $3,000, but you'll pay a slightly higher expense ratio for the privilege.

Vanguard Total Stock Market Index (symbols VTSAX, VTI) gets 40% of your assets. This fund gives you the entire U.S. stock market--large, midsize and small companies--for 0.05% annually. (That means you pay $5 a year for each $10,000 invested to cover expenses.) The fund tracks the CRSP U.S. Total Market Index, which includes some 3,800 stocks--making it much broader than the S&P 500. Still, large companies dominate the index, and the fund's return rarely deviates from the S&P by more than one percentage point or so in any calendar year. Over the past 10 years, the fund earned 8.6% annualized, an average of 0.6 percentage point per year more than the S&P 500. (All returns are through March 31).

Put 10% of your portfolio's assets into Vanguard Small-Cap Value Index (VSIAX, VBR). It invests in many of the stock market's smallest, cheapest and least-popular companies by tracking the CRSP U.S. Small Cap Value Index. There's overwhelming academic evidence that suggests that these stocks will outperform their more popular brethren over the long term, as they have in the past. But you need patience here. Over the past 10 years, the fund returned 9.1% annualized. Expenses are 0.09% annually.

Vanguard FTSE All-World ex-U.S. Index (VFWAX, VEU) gives you the rest of the world's bourses for 0.14% annually and deserves 20% of your assets. The fund tracks the FTSE All-World ex-U.S. index by investing in about 2,500 stocks from 44 countries. Roughly 20% of its assets are in emerging markets. U.S. stocks have trounced foreign stocks over the past five years, so it's not surprising that the fund's performance is anemic: an annualized 5.0%, or an average of 9.5 percentage points per year less than the S&P 500 over that period. But don't count on U.S. stocks to continue to outpace the rest of the world's. In investing, extrapolating the recent past into the indefinite future is a common and costly error.

Putting 5% into Vanguard Emerging Markets Stock Index (VEMAX, VWO) brings your overall investment in developing markets to 9% of assets when combined with the fund above. Roughly half of the stocks in the FTSE Emerging Index, which the fund tracks, are in China (25%), Taiwan (14%) and India (12%). Emerging markets have been dismal performers over the past five years, which explains this fund's pathetic return over that period of 1.8% annualized. But emerging-markets stocks are cheap, and the long-term argument for these fast-growing lands remains strong. Expenses are 0.15% annually.

I suggest placing the final 25% of your assets in Vanguard Intermediate-Term Corporate Bond Index (VICSX, VCIT). The risk-adjusted returns of intermediate bonds (that is, returns relative to volatility) have historically been stronger than those of both long-term bonds and short-term bonds. I prefer a corporate bond ETF over a total bond market ETF because the latter holds too many Treasury bonds, which yield less than corporate IOUs. Intermediate-Term Corporate Bond tracks Barclays Capital U.S. 5-10 Year Corporate Bond Index, and the average credit rating of its holdings is triple-B. The fund returned an annualized 6.8% over the past five years, but with bond yields so low, don't expect such generous returns to continue. Expenses are 0.12%.

This portfolio should serve you well until you're about 15 years from retirement. At that point, I'd boost the bond fund's allocation by five percentage points--subtracting one percentage point or so from each stock fund. Then add another five percentage points to your bond position every five years, reducing your stock fund allocation in the same manner, until you have 40% in bonds, a good bond weighting for the early years of retirement. Rebalance your portfolio annually to bring the funds back in line with the desired allocation.

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Steven T. Goldberg is an investment adviser in the Washington, D.C. area and a contributing columnist for Kiplinger. .