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Passive investing through index ETFs has become the dominant mode for most retail investors, with studies showing that active strategies largely fail to beat the index over most meaningful periods of time. The huge growth in the ETF industry, along with competitive pricing for most mainstream passive index products has made tracking any type of stock index extremely cheap and efficient.
However, there is still a lot of confusion about how to set up a portfolio with index funds, if the daily questions on Reddit’s Investing forum are anything to go by. Many new investors appear confused about which stock index to prioritize within their portfolios, how large of a position to take in each index and how to avoid overlap between their ETFs’ portfolios.
In order to answer these questions you should understand your risk tolerance and time horizon, consider preferences for exposure to various industry sectors, desire for exposure to smaller and mid-sized companies as well as setting a target for international stock exposure. Not every index is appropriate for every investing strategy.
Below we profile the most notable stock market indexes and the corresponding ETFs that provide access to them.
Please note, that these indexes and ETFs are described for informational purposes and do not constitute an investment recommendation or financial advice.
US Stock Indexes and ETFs
S&P 500 Index – The S&P 500 is perhaps the best know and most popular stock market index. It includes the 500 largest largest publicly traded US companies and is weighted by “market cap.” This means each component of the index is weighted based on its relative market cap to all other companies in the index. As a result, some companies (and some sectors) are weighted higher than others. For example, the top holding in the index at the time of writing is Apple, at 5.69%, and the top sector is technology, weighted at 23.33%. Other sectors, such as utilities and basic materials each have a weighting of less than 3% each.
It’s important to understand that the S&P 500 rebalances and adjusts based on new market caps, and if one sector or group of stocks expands their market cap value, these sectors and stocks will have an increased weighting. So while the S&P 500 is a diversified choice, you should be aware that it is not diversified evenly by sector and the top ten stocks in the index can take a substantial percentage of the overall index (and ETF that you own).
Notable ETFs that track the S&P 500 and are available by most brokerage accounts include the SPDR S&P 500 (SPY), iShares S&P 500 (IVV) and Vanguard S&P 500 (VOO). Note that all of these ETFs duplicate the same strategy and therefore you only need to hold one of them to get the full exposure to the index.
Dow Jones Industrial Average – If you hear about one index more often than the S&P 500, it’s the Dow Jones Industrial Average. While the news media loves to report on the Dow, it is not the most relevant or investable index because of its relatively small number of stocks (30) and it does not do the best job of capturing emerging industries or new companies. Like, the S&P 500, the Dow provides market cap weighted exposure, but to just 30 stocks, most of which are household names such as Goldman Sachs and Home Depot. The current top holding is UnitedHealth Group, which represents 7.5% of the index.
For investors seeking to replicate the performance of the Dow, the main ETF option is the SPDR Dow Jones Industrial Average ETF (DIA). It’s also important to keep in mind that there is significant overlap between stocks in the Dow Jones and S&P 500, so they are not ideal to combine together.
Nasdaq 100 index – The Nasdaq 100 is a popular index and has a distinct focus on technology and innovative companies from both the US and international companies. The Nasdaq has become a very popular index as it holds some of the most popular stocks among younger investors including Tesla (which was just recently also added to the S&P 500, as well), NVIDIA, PayPal and Starbucks. As mentioned, the NASDAQ is heavily weighted towards technology, with 44% of the portfolio in tech.
By far the most popular ETF to track the Nasdaq is the Invesco QQQ Trust (QQQ). Keep in mind, that many of the most popular names in the NASDAQ, such as the FAANG stocks (Facebook, Amazon, Alphabet, Netflix and Google) are also large holdings in the S&P 500. While some investors do hold both ETFs, you should be aware if holding both indexes that you will likely get a heavy tilt towards large-cap, US technology stocks.
Russell 2000 Index – Looking for something a little different? The Russell 2000 contains no less than 2000 stocks, none of which you will find in the indexes listed above. That’s because the Russell 2000 is the bellwether index of small-capitalization stocks, those that have a market cap between $300 million and $2 billion. Many investors pay attention and participate in the Russell 2000 because the companies give a truer picture of the domestic US economy than the S&P 500, which is composed of the largest US companies, most of which have substantial international operations. Just because the companies in the Russell 2000 are small relative to the S&P 500, it doesn’t mean they aren’t well-known. Some of the top stocks in the index include Plug Power, GameStop and Restoration Hardware.
The most notable ETF that tracks the Russell 2000 index is the iShares Russell 2000 ETF (IWM). Many investors allocate a certain percentage of their portfolio to small-cap stocks and pair it with the S&P 500. Small-cap stocks have historically provided slightly higher returns than their larger peers, but also come with more risk and volatility, so keep that in mind when deciding how large a percentage to dedicate to your portfolio.
S&P 400 index – If you’re trying to target stocks in between the largest and smallest cap stocks, the S&P 400 might be of interest. That’s because the S&P 400 captures mid-capitalization stocks, those trading at market caps between $2 billion and $10 billion. Mid cap stocks have “graduated” from the Russell 2000 but are not yet large enough to land in the S&P 500. Many are still primarily domestic companies although some will have global brands. Some recognizable stocks in the S&P 400 include Williams-Sonoma, Boston Beer Co. and FactSet Research.
The most notable ETF that tracks the S&P 400 is the iShares Core S&P 400 ETF (IJH). It fits perfectly in a portfolio as a complement to the S&P 500 and Russell 2000 ETFs for maximum exposure to large, mid-sized and small US stocks.
Russell 3000 Index – Want to simplify your life? Consider an index that tracks all of the above in one place—the Russell 3000. This index gives you market-weighted exposure to 98% of US stocks in one place. The media rarely mentions the Russell 3000 in its own right, because they prefer to report on the more notable indexes mentioned above to give investors a better idea of how large, mid and small stocks are doing as differentiated groups. However, for investors the Russell 3000 can be a useful representation of what all stocks in the US are doing as a group.
Luckily for investors, the Russell 3000 is available in a single ETF: the iShares Russell 3000 ETF (IWV). Like the other indexes, the Russell 3000 is market-cap weighted, which means the largest market-cap companies (Apple, Microsoft, Amazon, etc.) make up the top holdings. The IWM ETF is really for investors looking for in all-in-one solution to US equity exposure; it’s not particularly worthwhile to combine with the other ETFs listed above, unless you have a specific reason to.
International Stock Indexes and ETFs
MSCI EAFE Index – The EAFE (Europe, Australasia, Far East) Index is a broad-based index that covers developed international markets primarily in Europe, Asia, the Middle East and Australia. Investors seeking their first taste of international diversification can be potentially well-served by tracking this index. By investing internationally you get added exposure to different economic cycles than what is available in the US, as well as exposure to foreign currencies, as the majority of these companies earn profits in various international markets, as well as some in the US. The EAFE index features many companies you have heard of, ranging from the top stock Nestle, as well as Toyota, Unilever and Sony.
To track the EAFE index, you can invest in the iShares MSCI EAFE ETF (EFA), which gives you access to about 880 large international stocks. This ETF can be a great complement to any of the ETFs listed above, with no worries about stock overlap.
MSCI Emerging Markets Index – Looking farther afield than Europe and Japan? Some of the most exciting international companies such as Samsung, Tencent and Taiwan Semiconductor are not included in the EAFE index because they are headquartered in emerging markets such as South Korea, China and Taiwan. Other emerging markets with large economies and many notable companies include Brazil, India, Russia and Mexico.
Emerging markets are exciting in both good and bad ways. Certain eras have seen explosive growth (and returns) from markets like China and India, followed by market crashes and bouts of prolonged volatility. The currencies in emerging markets also tend to be volatile against the US dollar, adding another variable to investing there. Emerging markets also tend to exhibit above average political risk, with less stable governments that can also complicate life for your investments. All that being said, many investors seek out some exposure to emerging markets because of their growth potential and are willing to deal with the inevitable downturns.
There are many different ways to track emerging markets, from dividend strategies to a focus on smaller emerging market companies. If you are interested in only one market such as China, you can also look at China-specific ETFs. However, the largest and most well-known way to track the main MSCI Emerging Markets Index is the iShares MSCI Emerging Markets Index ETF (EEM). This ETF will provide exposure to well-known emerging markets companies including Alibaba, Tencent, Samsung and Taiwan Semiconductor. It also provides a great complement to the EAFE index, with no overlap between stock positions.
MSCI All Country World (Ex-US) Index – If you don’t want to bother with two separate international ETFs, the MSCI All World Ex-US Index provides comprehensive exposure to large international companies in both developed and emerging markets in one place based on market-cap weightings. It’s important to realize that due to their strong growth over the past decade, emerging market stocks make up some of the top holdings in this index and you should be aware of the potential volatility this could add to your portfolio. Among the the top ten holdings, the top four positions are all in emerging markets, with the next six including companies from developed markets including Nestle and Toyota.
The ETF to track this index is the iShares MSCI ACWI ex US ETF (ACWX). A similar ETF, VXUS, tracks the FTSE Russell ALL Cap ex US index, which provides similar all-in-one international stock exposure for those who prefer Vanguard funds.
MSCI All Country World Index – If you really just want ONE index that could deliver all of your stock exposure (both US and international), you could consider the MSCI All World Index, a global equity index that includes 3000 large and mid-cap stocks from 49 countries across the US, developed international and emerging markets. The index is slightly weighted towards US stocks, which make up about 56% of the index, with all other markets included making up the remainder. Only two of the top ten holdings are foreign: Taiwan Semiconductor and Tencent.
To invest in this index, you can select the iShares MSCI All Country World Index (ACWI). Generally speaking this the of ETF appeals to investors who want to hold a broad range of large company stocks from across the world without having to rebalance or allocate between a number of different funds. A similar fund that tracks a slightly different index is VT, for investors who prefer Vanguard funds.
The above is a guide to understanding the most notable stock market indexes and how you can invest in them directly through ETFs.