In 1976, Vanguard launched the first index fund. Since then, thousands more have come into existence, giving investors an easy and affordable way to buy a passively managed basket of stocks. Few inventions have produced as much wealth for everyday people as index funds. And if you're looking to build permanent passive income, there's one index fund in particular that you should be looking at now.
This is my favorite passive income index fund
My favorite index fund for passive income is actually an exchange-traded (ETF): the Vanguard Utilities ETF (VPU 0.43%). This one fund can provide you with reliable passive income for decades to come. What's its secret? There are two things to understand about this powerful ETF.
First, as its name suggests, this fund primarily invests in utility stocks. Utility businesses typically provide critical services to residential, industrial, and commercial end users, things like electricity, natural gas, and water. Demand for these critical services doesn't vary much during economic downturns, as turning off your water or heat is usually only an option of last resort. In this way, utility businesses have an ability to ride out economic storms easier than other industries. That helps keep their dividend rates strong even during times of turmoil.
The second thing to understand about this ETF is that it's one of the cheapest utility index funds out there when it comes to its expense ratio. Expense ratios gauge how much an ETF sponsor will charge you in return for managing the underlying portfolio. This ETF charges only 0.09% per year. According to Vanguard, the average expense ratio for this type of fund is significantly higher at around 1% -- that's 10 times higher than Vanguard's rate.
With this ETF, you're getting a very low-cost way of owning a diversified portfolio of economically stable businesses that regularly generate excess cash flow, enough to deliver a 2.9% dividend yield as of this writing -- more than double the dividend rate of the S&P 500. Plus, because your money is also invested in businesses that intend to grow over time, you also stand that chance of increasing your principle over time versus income generation alone.
But before you jump in, there's one thing every potential investor should understand about this income-generating index fund.
One rule for investing in the Vanguard Utilities ETF
The Vanguard Utilities ETF has a habit of outperforming the market during bear markets. In 2018, for instance, the S&P 500 lost roughly 4% of its value. The Vanguard Utilities ETF, however, gained about 4% in value. In 2022, the S&P 500 fell 18% in value. This ETF, meanwhile, rose in value by 1%. So far this year, the S&P 500 has declined by about 14%. Yet again, the Vanguard Utilities ETF has risen in value by an astounding 5.2% -- an outperformance by nearly 20% in a matter of months.
But here's the catch: During strong bull markets, expect this ETF to lag the overall market, sometimes by significant margins. In 2023, for example, the S&P 500 rose by 26% while this utilities ETF fell in value by 7% -- an underperformance of more than 30%.
The stability of utility businesses works both ways. It protects investors during down markets, but limits upside during bull markets. This is the biggest rule for investing in this ETF: Don't expect to get rich. Instead, the Vanguard Utilities ETF should be viewed as a lower-risk, income-producing investment vehicle for risk-averse investors like retirees, or simply for investors looking to stash away an emergency fund for a few years of extra growth and limited risk. If you're in either of those two categories, this index fund should top your buy list.
