Do you ever hear news reports that the stock market rallied, or that it tanked due to a piece of worrisome news? Often in these reports, the stock market refers to the S&P 500 index, which represents about 80% of the U.S. stock market.
An S&P 500 index fund is a fund that tracks the performance of the S&P 500 index. These are among the most popular investments on the planet, and for good reason. An S&P 500 index fund can make practically anyone wealthy, given enough time and patience.
Here’s how S&P 500 index funds work and why they’re a safe and reliable choice for most investors.
What Is an S&P 500 Index Fund?
The S&P 500 is a stock index that tracks the performance of stocks in the S&P 500 index. (There are actually 503 stocks in the S&P 500 because three of the companies issue two classes of shares.)
It’s the most widely tracked stock index in the U.S., followed by the Dow Jones Industrial Average and the Nasdaq. When you hear in the news that stocks rallied or stocks plunged, often that means that the overall prices of those 503 stocks in the S&P 500 trended upward or downward.
An S&P 500 index fund is a pool of stocks designed to track the S&P 500. With one single investment, you’re automatically invested across all 500 companies in the index.
If the S&P 500 index goes up by 20% in a year and you’ve invested in an S&P 500 index fund, you’d expect returns of about 20%, minus investment fees, which are usually minimal. If the index falls by 20%, you’d expect the value of your investment to drop by 20% as well.
The goal isn’t to beat the market. Instead, an S&P 500 index fund aims to replicate the performance of the S&P 500 index as closely as possible.
Though some years, like 2022, the S&P 500 index will drop, it has about a 75% chance of gaining value in any given year, with annual returns averaging about 10%. Maybe that doesn’t sound like a lot, particularly in comparison to the mind-boggling returns investors saw in 2020 and 2021. But over long periods of time, those returns can produce substantial returns.
If you invested $500 a month and earned 10% annual returns, you’d have nearly $1 million after about 30 years. Your total investment? Just $180,000.
S&P 500 index funds have a phenomenal track record of building wealth over time. In fact Warren Buffett, who’s arguably the most successful stock picker on the planet, believes most investors should stick with S&P 500 funds instead of choosing their own stocks. In 2008, the Oracle of Omaha famously waged a bet with investment managers that an S&P 500 index fund could beat a pool of hedge funds over 10 years — and won.
Buffett believes in S&P 500 funds so much so that he’s directed the trustee of his estate to invest 90% of his money in S&P 500 funds for his wife when he dies. The remaining 10% will go to short-term Treasury securities.
What Is the Best S&P 500 Index Fund?
There’s no “best” S&P 500 index fund. They’re made up of the same investments, so they pretty much deliver the same returns. And you don’t need to own more than one S&P 500 index fund since they all track the same index.
You can find S&P 500 funds that are exchange-traded funds (ETFs), which are traded like individual stocks on stock exchanges, or mutual funds, which you can buy directly from an investment company or with a brokerage account.
If you have a 401(k), you may already own S&P 500 index funds, as they tend to be popular options for retirement plans.
The main thing you should focus on is low fees. Look for an expense ratio of 0.1% or less. Choosing a fund with a low minimum upfront investment is also a good bet. With ETFs, you can often invest as little as $1 thanks to fractional investing. Some mutual funds require an upfront investment of $1,000 to $2,000, but many have no minimum investment.
The Pros and Cons of Investing in an S&P 500 Index Fund
Here are the pros and cons of S&P 500 index funds. Spoiler alert: There are a lot more pros than cons, especially if you’re a beginning investor.
S&P 500 Index Fund Pros
- With a single investment, you get an automatically diversified portfolio. That’s a fancy investor way of saying you spread out your risk instead of putting all your eggs in one basket. You’re invested in 500 companies across all 11 stock market sectors. That’s why investing in an S&P 500 index fund is a lot less risky than investing in stocks of individual companies.
- The S&P 500 produces reliable long-term returns. Over the past 30 years, the S&P 500 has delivered average annualized returns of around 10%. That doesn’t mean you can’t lose money. The S&P 500 fell more than 50% during the Great Recession of 2007 to 2009. In 2022, the index has tanked by nearly 20%, putting it close to bear market territory. But historically, the S&P 500 has always rebounded over the long term.
- Their fees are minimal. Because you’re not paying for professionals to handpick investments for you, investment costs are low. Many S&P 500 index funds have an expense ratio of less than 0.1%, meaning that less than 0.1% of your investment is spent on non-investment costs. If you invest $1,000 in a fund with a 0.1% expense ratio, $999 of your money will go toward the actual investment.
- Passive management typically beats active management. Don’t let the idea of sitting back and letting your money roll with the overall S&P 500 scare you. After fees, most active managers underperform their benchmark index.
- You’re investing in major corporations with a profitable track record. To be included on the S&P 500, a company needs to have a $14.6 billion market capitalization, which is the total outstanding value of all its shares. They’re also required to have at least four consecutive profitable quarters under their belts. If a company runs into financial trouble, it risks being delisted.
S&P 500 Index Fund Cons
- There’s less potential for big rewards. A drawback of investing in any index fund is that you don’t have the potential to hit the jackpot by picking the next Google or Amazon. You also won’t outperform the market, because the fund’s performance goes hand-in-hand with the S&P 500’s performance.
- The S&P 500 is heavily concentrated on a few giants. Yes, you become an investor in 500 corporations when you buy an S&P fund. But because the index is weighted by market cap, your money isn’t distributed evenly across those companies. At the end of 2022, the top 10 S&P 500 companies by market capitalization accounted for 25% of the S&P 500’s value.
That can pose problems when one sector becomes heavily weighted. For example, at the end of 2020, five tech stocks represented more than 20% of the index’s value. That spelled trouble for the S&P 500 index in 2021 and 2022, as tech stocks faltered.
- Giant corporations have less room for growth. The companies in the S&P 500 are among the most successful and stable in their respective industries. One downside to that: They’re already so big that they have less room to grow. Small-cap stocks, or those with a market cap under $2 billion, usually have the most growth potential, though they’re also a lot riskier.
Robin Hartill is a certified financial planner and a senior writer at The Penny Hoarder. She writes the Dear Penny personal finance advice column. Send your tricky money questions to [email protected]