Index investing can give you exposure to a lot of stocks all at once, removing the risk of putting all your investment eggs in one basket. Figuring out which index fund to buy, though, can be tricky. There are a lot of index funds and index ETFs to choose from, but three of our top Motley Fool contributors think the iShares Russell 2000 ETF (IWM 2.69%), SPDR S&P Dividend ETF (SDY 1.46%), and the Schwab Total Stock Market Index Fund (SWTSX) make the most sense to buy now. Are these funds right for your portfolio?
Time to think small
Todd Campbell (iShares Russell 2000 ETF): 2017 was a great year for all stocks, but owning small-cap stocks could be the better bet in 2018 and beyond.
The iShares Russell 2000 ETF underperformed the S&P 500 by about 5% in 2017, and as a result, the average stock in the index has a lower price to book ratio and price to sales ratio than the average stock in the S&P 500. Additionally, tailwinds tied to tax reform, wage growth, and a potential increase in infrastructure spending could help small-cap stocks outperform large-cap stocks from here.
Currently, the Russell 2000 and S&P 500 boast similar forward price to earnings ratios, but the Russell 2000's price to book ratio is only 2.15 compared to the S&P 500's 3.1, and its price to sales ratio is just 1.24 versus the S&P 500's 2.28. The Russell 2000's lower ratios suggest investors are undervaluing small company break-up values and revenue relative to bigger peers.
Because small companies in this index get most of their revenue from the U.S. market, their profitability should benefit significantly from dropping the corporate tax rate to 21% from 35%. They'll also benefit most from the change to immediate expensing on certain capital expenditures and from GDP growth due to rising U.S. wages. If an infrastructure spending bill passes in 2018, it could lend even more support to smaller stocks.
Admittedly, small-cap stocks tend to be more volatile, and that makes owning them risky. Rising interest rates can weigh on profitability by increasing borrowing costs, too. Nevertheless, small stocks historically tend to generate greater average annual returns than big stocks, and given these tailwinds, I think it's a good time to begin dollar-cost averaging into the iShares Russell 2000 ETF in retirement accounts.
Did someone say dividend income?
Sean Williams (SPDR S&P Dividend ETF): With the stock market seemingly hitting new highs every week, many investors are likely eyeing growth stocks. As for me, I believe strong dividend stocks might be the smarter choice over the long run, which is why the SPDR S&P Dividend ETF may deserve a place in your IRA.
The SPDR S&P Dividend ETF tracks the total performance of the S&P High Yield Dividend Aristorcrats Index. What makes this index so special is that it screens for companies that have consistently increased their annual payout for a minimum of 20 years, then it weights those stocks based on yield, giving precedence to those with the highest yields. While chasing high yields can often be a dangerous game, scanning for those companies with a track record of dividend hikes weeds out those companies that don't have sustainable business models. It also, presumably, selects companies that can deliver steady growth. After all, companies wouldn't be increasing their stipend annually if they weren't growth their bottom line.
Another reason to be excited about the SPDR S&P Dividend ETF is the expected passage of the GOP tax plan. This sweeping tax reform will lower the corporate tax rate from 35%, one of the highest peak marginal rates in the world, to just 21%. That's going to put more money in the pockets of business, which I suspect will result in a boost in stock buybacks and dividends.
Investors in this ETF also won't have to hand over an excessive amount of money in management fees and other expenses. The net expense ratio is a mere 0.35% annually, which is more than covered by the current yield of 2.24%. If you want safety and income, this index fund is a smart route to consider for your IRA.
A massive portfolio at a tiny price
Jordan Wathen (Schwab Total Stock Market Index Fund): It's tough to beat the Schwab Total Stock Market Index Fund as a way to own virtually every single stock on American markets. The fund tracks the Dow Jones U.S. Total Stock Market Index, which includes all U.S. headquartered companies of practical size.
The big advantage of this fund is that it offers diversity at a low cost. Carrying an annual expense ratio of just 0.03%, investors pay as little as $3 in expenses each year for every $10,000 invested. That compares favorably to an average expense ratio of 0.09% for index funds and 0.82% for actively managed funds in 2016, according to Investment Company Institute.
Total stock market index funds are an excellent way to get broad exposure to companies of all sizes on all exchanges. While large-caps dominate the list of holdings -- it weights its investments by the market value of the company -- it ventures down to the smallest 5% of companies, thus giving you exposure to some very small stocks.
As an added bonus, investors can get started with this fund without depleting their savings. The fund allows for initial investments as low as $1.00, making it a great choice for people who want to start small and add to their investments over time.