Once you have determined your target asset allocation between stocks and bonds, it’s time to create an index fund portfolio by selecting index funds. In this post, we will discuss the main indexes that you can track in our portfolios.
The goal is to create an index fund portfolio that can have as few as 2 to 3 index funds, yet be extremely diversified and able to deliver solid financial performance in the long term. The simpler the portfolio is, the easier it will be to manage.
Please note that the following index funds and investment products are only shared for general education purposes. This is not investment advice and you should do your own research!
Major Stock indexes
Diversified investors will include both equity funds from the United States and the rest of the world in their portfolios.
US stocks are a stand-alone category because the value of US companies constitutes about 50%-60% of the world market capitalization. This table from the World Bank shows the market capitalization of US companies compared to the rest of the world. Among the top companies in the United States, we have global leaders such as Apple, Microsoft, Alphabet (the company that owns Google), Amazon, Tesla, NVIDIA, Berkshire Hathaway (the holding company controlled by Warren Buffett), Meta (the company that owns Facebook).
The rest of the world accounts for the remaining 40-50% of the global market capitalization. Global stocks are commonly subdivided into developed and emerging markets. Emerging markets stocks have a higher risk-return profile compared to developed markets.
Balancing US stocks and rest of the world stocks in your portfolio
Since the capitalization of US companies constitutes about 50% of the world capitalization, many investors that want to track the global stock market have 50% of their equities allocation into US stocks and 50% into international stocks.
There are many indexes that can be tracked via index funds that target the global stock market replicating this asset allocation. These indexes can be a single equity solution for your portfolio if you want to keep things as simple as possible. The major indexes include the MSCI ACWI, MSCI World, and FTSE Global All Cap indexes.
As of March 2022, both the MSCI ACWI and the FTSE Global All Cap invested 60% in US companies and 40% in the rest of the world, including emerging markets. The MSCI World has a more conservative allocation because it excludes emerging markets. It invests about 65% in the United States companies.
US Stock indexes
Large cap
One of the major US stock market indexes is the S&P500 index, which tracks the largest 500 companies in the United States, including Apple and Microsoft.
The S&P500 is one of the most renewed indexes in the world. It was one of the first to have an associated index fund in 1975 when Jack Bogle launched the First Index Investment Trust. As you may recall from our passive investing post, it is also the index that Warren Buffett wants his trust to track upon his death.
The S&P500 index can be a great solution for many investors because it is very representative of the large-capitalization stock market in the United States.
Two low-cost ETFs that you can use to track the S&P500 in the United States are the SPY and IVV. They have a gross expense ratio between 0.1% and 0.03%.
If you live anywhere else in the world, you will certainly find ETFs or mutual funds that track the S&P500.
Total US stock market
Some investors seek even more diversification throughout the US stock market by including small and mid-capitalization companies. They can either pair the S&P500 with mid-cap and small-cap index funds, or invest in a total market fund. A total US stock market fund tracks the US stock market as a whole by including large, mid, and small cap.
One of the major indexes to represent the total US stock market is the CRSP US Total Market Index. It includes about 70% of its portfolio in large-cap and 30% in mid and small-cap. A mutual fund that tracks this index is the low-cost Vanguard mutual fund VTSAX, which invests in over 4000 companies.
Financial performance of the S&P500 and total US stock market
Both the S&P 500 and the CRSP US Total Market indexes weigh their holdings (portfolio companies) by their market capitalization. Since companies with a large capitalization are overly represented in both indexes, their portfolios overlap significantly. As a result of this overlap, their financial performance is also very aligned. So please do not be worried if you can only invest in one of them, they are quite similar.
In recent years, the CRSP US Total Market Index has performed slightly better than the S&P 500. That is because it includes small capitalization and medium-capitalization companies that have a higher risk-return profile.
Since the performance of the US stock markets has been spectacular in recent years, many investors only invest domestically. Since I live in the United States, I know quite a few of them.
A common argument in their favor is that major US corporations are global companies that operate all over the world. Companies like Apple, Microsoft, and Google generate global revenues, and the global economy influences their growth and profits.
Because of the sheer size of the stock market of the United States compared to global financial markets, I think that this is the only country in the world where local investors can get away with a fully domestic exposure. Japanese investors from the 1980s know this fair too well.
Yet, I don’t think that investing exclusively in the United States is a safe bet in the long run. Emerging economies like China may become the next global superpowers. They may overtake the United States in the not so distant future. So integrating global indexes may enable you to capitalize on future global economic opportunities.
A global index will rebalance its exposure to specific countries based on pre-set rules, such as local companies’ market capitalization. So you don’t have to worry about tracking individual economies.
International (rest of the world) indexes
To achieve global exposure, you should include one or more funds that track indexes in the rest of the world. Some examples include the FTSE Global All Cap ex US Index, which includes both developed and emerging markets. You can invest in it through the VXUS ETF by Vanguard in the United States to track both developed and emerging markets.
If you want to have more control over the exposure to developed and emerging markets, you may consider specialized indexes. For instance, the FTSE Russell Group (FTSE) also created the FTSE Developed All Cap ex US Index to track developed markets; and the FTSE Emerging Markets All Cap China A Inclusion Index to track emerging markets.
Bond indexes
Among the major bond indexes, we have the Bloomberg Barclays U.S. Aggregate Float Adjusted Index for US bonds; and the Bloomberg Global Aggregate (USD Unhedged) Index for global bonds. You can find plenty of mutual funds or ETFs tracking these two indexes all over the world.
Both of these indexes have intermediate portfolio duration, a measurement of their price sensitivity to changes in prevailing interest rates. Indeed there is an inverse relationship between the prevailing interest rates (e.g. the interest rate on government bonds) and the price of existing bonds. When interest rates go up, the price of existing bonds goes down.
The price of bonds with a short duration will be less affected by changes in the interest rates than bonds with a long duration. This means that in times when interest rates are low, you may want to select bond indexes with a shorter duration. Their price will not go down as much as bonds with a longer duration. One example of a short duration bond index is the Bloomberg Barclays U.S. 1–5 Year Government/Credit Float Adjusted Index.
But if you want to minimize the complexity of your portfolio and choose a single bond fund, then stick to intermediate duration bond funds and stay invested in the long run. In the long term, the intermediate duration bond funds will rebalance their portfolios regularly to maintain unvaried their target duration and this will give you exposure to newly issued bonds at the prevailing interest rates.
What this guide is not covering
Since this is an introductory portfolio, I have tried to keep it simple and only focused on major asset classes. These are portfolios that anyone can build with just 2 or 3 ETFs and achieve global exposure and diversification.
More experienced investors will likely consider including in their portfolios other sub-asset classes or specific investment strategies that better match their risk-return profile.
These include structures like REITS to track real estate investments in public markets, high dividend-paying stocks, mid-capitalization and small-capitalization stocks, and growth and value portfolio factors.
We will discuss these in future blog posts. But you really don’t need to know about them to get started with investing. This guide already includes the building blocks of a simple yet powerful passive investment portfolio!