The best index funds can help you to build wealth by diversifying your portfolio while minimizing your fees. Investing in an index fund is less risky than investing in individual stocks or bonds because index funds often hold hundreds of securities. Index funds spread your investment risk across the stocks or bonds of many different individual companies.

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How to pick an index fund

Index funds hold baskets of investments in order to track a market index, such as the S&P 500 (SNPINDEX:^GSPC). Index funds are passively managed, meaning that the fund's holdings are determined entirely by the index the fund tracks. The goal of an index fund is to match the performance of the underlying index.

The returns generated by an index fund generally never exceed the performance of the index itself, if only because of index funds' expense ratios, which are the annual management fees collected by index fund managers. Index funds, being passively managed, are actually more likely over the long term to outperform funds with active managers.

An index fund can either be a mutual fund or an exchange-traded fund (ETF). Investors buy shares of mutual funds directly from asset management companies, whereas shares in ETFs are purchased and sold via stock exchanges.

Consider these key factors when picking an index fund:

  • Target market segment: Some index funds confer portfolio exposure to the entire U.S. stock market by tracking indexes such as the S&P 500, while other index funds track narrower indexes that focus on specific stock market sectors, industries, countries, or company sizes.
  • Your investment goals: Some stock market indexes, and, by extension, some index funds, track companies with specific characteristics such as high growth potential, a history of reliable dividend payments, or adherence to environmental, social, and governance (ESG) standards.
  • Expense ratio: An index fund's expense ratio, which is the percentage of your investment that is annually paid as a management fee to the index fund's manager, can vary significantly. A good expense ratio for a total stock market index fund is about 0.1% or less, and a small number of index funds have expense ratios of 0%. More specialized index funds tend to have higher expense ratios.
  • Minimum required investment: Some mutual index funds have minimum investments of $1,000 or more. ETF index fund are accessible for the cost of a single share.
  • Benchmark tracking performance: How closely an index fund tracks its underlying index can vary. The performances of the best index funds are very closely correlated with their benchmark indexes.

Nine best index funds for 2021

Our picks for the nine best index funds for 2021 can help you accomplish a variety of investment goals, plus they have low expense ratios and low minimum investments.

1. Fidelity ZERO Large Cap Index Fund

Investing in S&P 500 index funds is perhaps the closest thing to a guaranteed way to build wealth over time. The Fidelity ZERO Large Cap Index Fund (NASDAQMUTFUND:FNILX), which tracks an index of just over 500 U.S. large-cap stocks, performs very similarly to an S&P 500 index fund. But because this fund is not an official S&P 500 index fund, it avoids paying expensive licensing fees to S&P Global (NYSE:SPGI), the index's parent company. The fund tracks the Fidelity U.S. Large Cap Index as its benchmark.

This index fund delivered a total return of 20.05% in 2020, beating the S&P 500's total return of 17.4% for the same period. The "ZERO" in the fund's name denotes that the expense ratio for this fund is 0%. There's also no minimum investment amount, making the fund a good choice for beginner investors.

2. Schwab S&P 500 Index Fund

If you want to invest in an official S&P 500 index fund, then the Schwab S&P 500 Index Fund (NASDAQMUTFUND:SWPPX) is about the cheapest you'll find. Its expense ratio is 0.02%, meaning you'd annually pay just $0.20 for every $1,000 you invest. Because this investment fee is so tiny, your returns are virtually identical to the performance of the S&P 500.

As of July 2021, the fund's year-to-date total returns were roughly 18%. There's no minimum investment amount, so you can start investing with as little as $1.

3. Vanguard Growth ETF

If you want to assume more investment risk in pursuit of higher rewards, then the Vanguard Growth ETF (NYSEMKT:VUG) is a solid choice. The fund tracks the CRSP US Large Cap Growth Index, which performs similarly to the S&P 500 Growth Index. This ETF invests in 255 U.S. large-cap growth stocks. Tech stocks are heavily represented, accounting for 47% of the fund's holdings, followed by consumer discretionary stocks (22.7%) and industrial stocks (13.4%). Energy stocks and utility stocks combined comprise only 0.7% of the fund's value.

The VUG has a minuscule 0.04% expense ratio. As of June 30, 2021, the fund's average annual return over five years, before taxes, was 23.06%.

4. SPDR S&P Dividend ETF

A top index fund for income-oriented investors is the SPDR S&P Dividend ETF (NYSEMKT:SDY). This dividend-weighted fund's benchmark is the S&P High Yield Dividend Aristocrats Index, which tracks 112 of the stocks in the S&P Composite 1500 Index with the highest dividend yields. All of the companies owned by this ETF have increased their dividend payments annually for at least 25 consecutive years.

This fund's 12-month dividend yield at the time of this writing is 2.65% — well above the S&P 500's 1.34%. The expense ratio is also somewhat higher at 0.35%.

The fund's top five holdings are ExxonMobil Corp. (NYSE:XOM), AT&T (NYSE:T), utility company South Jersey Industries (NYSE:SJI), pharmaceutical company AbbVie Inc. (NYSE:ABBV), and Chevron Corp. (NYSE:CVX). It includes many real estate investment trusts (REITs), which typically pay high dividends because they're required to disburse at least 90% of their taxable incomes. This ETF is underweighted in tech stocks, which don't tend to pay generous dividends.

5. Vanguard Real Estate ETF

If you want to invest across the real estate market, the Vanguard Real Estate ETF (NYSEMKT:VNQ) is a solid, low-cost option. With an expense ratio of 0.12%, it's also by far the largest real estate index fund, with about $75 billion assets under management.

Its benchmark index is the MSCI US Investable Market Real Estate 25/50 Index, which broadly tracks the U.S. real estate market. Although the index includes a few real estate management and development companies, it consists mostly of equity REITs, which own and operate income-producing real estate.

This ETF is also attractive to dividend investors since the fund's 12-month dividend yield at the time of this writing is 2.34%.

6. Vanguard Russell 2000 ETF

The Vanguard Russell 2000 ETF (NASDAQ:VTWO), which tracks the Russell 2000 (RUSSELLINDICES:^RUT), is a good place to start for investors who want to take advantage of the potential upside of investing in small-cap companies. The fund invests in 2,113 small-cap and mid-cap companies that have a median market capitalization of $3.3 billion.

As of May 31, 2021, this index fund's largest concentration was in consumer discretionary companies (17.8%), healthcare companies (17.6%%), and industrial businesses (15.8%). The fund's expense ratio, at 0.1%, is relatively low, especially for a fund that offers exposure to the companies with the most growth potential.

In 2020, the Vanguard Russell 2000 ETF outperformed the S&P 500 with a total return of 20.2%.

7. iShares MSCI China ETF

The iShares MSCI China ETF (NASDAQ:MCHI), which more or less mirrors China's equivalent to the S&P 500, vastly outperformed the S&P 500 in 2020 with a total return of 28.89%. Its expense ratio is 0.59%, which, according to ETF.com, is slightly lower than the average of 0.70% for a China ETF.

Although adding international exposure to your portfolio is key to diversification, and China's growth potential is immense, investing in the world's second-largest economy poses some major risks. Chinese accounting standards are lacking, there's the risk of trade disputes, and uncertainties surround the global recovery from the COVID-19 pandemic. While Chinese stock prices surged in 2020, it's worth noting that Chinese stocks in the past decade have performed poorly compared to U.S. stocks.

8. Schwab Emerging Markets Equity ETF

If you're seeking portfolio exposure to high-growth emerging markets but don't want your risk concentrated in a single economy or region, the Schwab Emerging Markets Equity ETF (NYSEMKT:SCHE) may be a good fit. It tracks the FTSE Emerging Index, a collection of large- and mid-cap stocks in more than 20 developing countries. The fund has 1,641 holdings, with the largest concentrations in China, Taiwan, India, Brazil, and South Africa. Its expense ratio is only 0.11%.

The stocks of companies in emerging markets have historically underperformed compared to U.S. stocks. In the past decade, the Schwab emerging market funds, on a combined basis, have had total returns of just under 45% -- versus nearly 300% for the S&P 500. But considering that about 85% of the world's population lives in developing countries, investors with a long-term focus who are comfortable with volatility may want to seriously consider investing in this fund.

9. Fidelity U.S. Sustainability Index Fund

Investors who are interested in sustainable investing should check out the Fidelity U.S. Sustainability Index Fund (NASDAQMUTFUND:FITL.X). The fund's benchmark is the MSCI USA ESG Leaders Index, which tracks the performances of large- and mid-cap domestic stocks with above-average environmental, social, and governance (ESG) ratings. The index fund has a low expense ratio of 0.11% and no minimum investment amount.

The fund's largest concentrations at the time of this writing are in the technology (27.11%), healthcare (13.43%), and consumer discretionary (12%) sectors. This sustainability ETF's top holdings are Microsoft (NASDAQ:MSFT), Google parent Alphabet (NASDAQ:GOOG) (NASDAQ:GOOGL), Tesla (NASDAQ:TSLA), and Johnson & Johnson (NYSE:JNJ).

While ESG investing is appealing to many, a strong ESG focus is also good for returns. Companies that pose little ESG-related risk often deliver superior financial performance, making ESG funds such as the Fidelity U.S. Sustainability Index Fund a good choice for long-term investors.