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3 Top Index Funds for Your IRA

By Keith Noonan, Daniel Miller, and Maxx Chatsko – Updated May 24, 2018 at 9:39AM

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These three funds could make for smart additions to your IRA.

Index funds can offer convenient ways to build positions in a wide range of stocks and reduce the risk profile of your investments. For retirement-focused portfolios, this lower-risk approach to investing can be a great fit, but it's also important to proceed with the understanding that not all index funds are created equal.

Some funds offer advantages such as cheaper ownership costs or holdings that better position investors to take advantage of the tax-advantaged status of individual retirement accounts (IRAs), and selecting the right ones can make a big difference in the performance you see over time. Read on to see why three Motley Fool investors have identified Vanguard Tax-Managed Small-Cap Fund Admiral Shares (VTMSX -60.80%), Vanguard Dividend Appreciation (NYSEMKT: VIG), and Vanguard High Dividend Yield ETF (VYM -1.73%) as top index funds for your IRA.

A pen on top of sheets off paper displaying graphs.

Image source: Getty Images.

Go for growth

Maxx Chatsko (Vanguard Tax-Managed Small-Cap Fund Admiral Shares): When it comes to index fund management, Vanguard is the undisputed champion. That's why it has some $5.1 trillion in assets under its helm. The no-nonsense, low-fee approach has also proven to be very kind to long-term investors looking to build wealth. That has been especially true for the Vanguard Tax-Managed Small-Cap Fund over the years.

The index fund only holds small-cap companies, which means it's a bit riskier than your run-of-the-mill group of holdings that track the broader market. After all, small-cap stocks have a higher rate of failure than mid-cap or large-cap stocks that represent more mature businesses.

That said, more risk means more reward, and Vanguard has expertly managed that risk since the fund launched in March 1999. The Vanguard Tax-Managed Small-Cap Fund has put up an annual rate of return of 11% since its inception -- and that includes the dot-com bubble burst and the Great Recession. It has treated investors well, as $10,000 invested one decade ago would be worth $28,416 today -- and that includes the Great Recession. It's difficult to beat that performance with such little effort.

The fund comes with an expense ratio of just 0.09%, which is 92% lower than the average fund with similar holdings. However, because it's included in Vanguard's Admiral Shares offerings, the minimum initial investment is $10,000, which is higher than starting commitments for other funds. Nonetheless, this is among the simplest ways to earn above-average returns on your hard-earned money.

Income and broad market exposure

Keith Noonan (Vanguard High Dividend Yield ETF): Owning stakes in dividend-paying companies creates a source of income that can help support you in retirement, and the tax-advantaged status of IRAs opens avenues to keeping more of your payouts to reinvest and compound. These qualities make dividend-paying stocks or dividend-focused funds a smart fit for IRAs, and Vanguard's High Dividend ETF is a top choice for investors seeking dependable yield and diversified market exposure.

Vanguard's High Dividend ETF, or VYM, as it's tickered and sometimes called, bundles together 384 stocks in a low-expense vehicle for broad ownership in companies with above-average yields. The fund carries a roughly 2.9% yield as of this writing and tracks the FTSE High Dividend Yield Index -- which consists of stocks on the FTSE All-World Index that have above-average dividend yields.

The average trailing price-to-earnings ratio for the fund is roughly 18.5 -- a good bit below the S&P 500's P/E of roughly 24, and reflective of the fact that many of the companies that make up VYM's largest holdings are in mature stages of a growth cycle. Dividend-paying stocks can provide investors with some protection in the event of a market downturn, and the Vanguard High Dividend Yield ETF's composition and income profile make it a worthwhile buffer against volatility.

The VYM's 10 biggest holdings account for roughly 33.1% of the fund's total weight and are listed in the table below:

1. Microsoft 6. Wells Fargo & Co.
2. JPMorgan Chase & Co. 7. AT&T Inc.
3. Johnson & Johnson  8. Chevron Corp.
4. ExxonMobil Corp. 9. Cisco Systems Inc.
5. Intel Corp. 10. Pfizer Inc.

Data source: Vanguard. 

As with many of its funds, Vanguard's high-yield ETF offers comparatively low fees. The company notes that the ETF's annual 0.08% management fee is 92% lower than the average fund consisting of similar holdings. With a reasonable expense profile and exposure to a wide range of stocks, Vanguard's High Dividend ETF presents an easy way to build an income-generating position in the market and should be a stand-out top candidate for investors seeking to add low-risk index funds to their IRAs. 

Appreciating dividends

Daniel Miller (Vanguard Dividend Appreciation): Investors looking to add funds to their IRAs would be wise to consider the Vanguard Dividend Appreciation ETF. It owns a diverse portfolio of highly profitable U.S.-based dividend stocks that have increased their dividends consistently over the past 10 years. It's an excellent management style as companies that regularly increase their dividends generally have sustainable competitive advantages, making it a great fund to own in your IRA.

The fund's top five holdings are massive companies that all likely have products in your household: Walmart, Johnson & Johnson, Microsoft, PepsiCo. and 3M Co. Vanguard Dividend Appreciation is also a solid selection as it's one of the cheapest dividend-oriented funds out there, with the fund charging only eight basis points.

This isn't a fund that's going to shock you with eye-popping dividend yields: Its 12-month yield is 1.89%. That's by design, though, as management screens for profitability and avoids riskier, high-yield stocks -- the fund focuses on dividends that are about to grow. And by owning companies with increasing dividends, which often have competitive advantages, the fund has performed well in the past during bear markets. All in all, this is an excellent fund to own as it's inexpensive, diversified with stable companies, and the extra income from a dividend focus is the cherry on top.

Teresa Kersten is an employee of LinkedIn and is a member of The Motley Fool's board of directors. LinkedIn is owned by Microsoft. Daniel Miller has no position in any of the stocks mentioned. The Motley Fool owns shares of and recommends Johnson & Johnson. The Motley Fool recommends 3M, Cisco Systems, and Intel. The Motley Fool has a disclosure policy.

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Stocks Mentioned

Vanguard High Dividend Yield ETF Stock Quote
Vanguard High Dividend Yield ETF
$97.13 (-1.73%) $-1.71
Vanguard Tax-Managed Funds - Vanguard Tax-Managed Small-Cap Fund Stock Quote
Vanguard Tax-Managed Funds - Vanguard Tax-Managed Small-Cap Fund
$75.22 (-60.80%) $0.46
Vanguard Index Funds - Vanguard Total Stock Market ETF Stock Quote
Vanguard Index Funds - Vanguard Total Stock Market ETF
$92.25 (-24.90%) $0.23

*Average returns of all recommendations since inception. Cost basis and return based on previous market day close.

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