If you want your portfolio's value to grow with the U.S. economy and don't want to choose individual stocks, an S&P 500 index fund could be a smart choice. In fact, legendary investor Warren Buffett has said that investing in low-cost S&P 500 index funds is a bet on the future of U.S. economic growth and the best way for most people to build wealth.

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What are index funds and why are they popular?

An index fund is designed to mirror the performance of a stock index. An S&P 500 index fund invests in each of the 500 companies in the S&P 500 (SNPINDEX:^GSPC). It doesn't try to outperform the index; instead, it uses the index as its benchmark and aims to replicate its performance as closely as possible.

While S&P 500 funds are by far the most popular type of index fund, index funds can be, and are, based on practically any financial market, investing strategy, or stock market sector

Index funds are popular with investors for a number of reasons. They offer easy portfolio diversification, with some funds enabling portfolio exposure to hundreds or even thousands of stocks and bonds. You don't risk losing all your money if one company performs poorly or collapses like you would with individual investments, but you also don't get exposure to the potentially astronomical returns that can result from picking a huge winner.

Index funds are passively managed, which means you're not paying for someone to actively pick and choose investments. This results in a lower expense ratio, e.g., lower investment management fees as compared to actively managed funds. 

Here are four good reasons to invest in S&P 500 index funds:

1. Your money will track the market's performance.

Historically, the S&P 500's annual returns have been in the 9% to 10% range. Some years, the index will lose value, of course. During the Great Recession, the S&P 500 lost about 50% of its value. But over the long term, it's always recovered. Never in the S&P 500's history has a 20-year investment resulted in a loss.

2. You keep more of your investment profits in your pocket.

Buffett's case for low-cost S&P 500 index funds centers on their low fees. While active managers are likely to match the market's performance over time, their fees eat away at your returns. Buffett famously won a $1 million bet against investment manager Ted Seides that a low-cost S&P 500 index fund could beat a hand-selected hedge fund portfolio over 10 years.

3. You're investing in 500 of the most profitable companies in the U.S. 

The corporations represented in the S&P 500 are subject to stringent listing criteria. To join the index, a company must have a $9.8 billion market capitalization, and the sum of its past four quarters' earnings must be positive. Each company must also get approval from an index committee. Some of the S&P 500's largest holdings include Apple (NASDAQ:AAPL), Amazon (NASDAQ:AMZN), Microsoft (NASDAQ:MSFT), and Johnson & Johnson (NYSE:JNJ).

4. You can put your investment decisions on autopilot. 

The S&P 500 has a flawless track record of delivering profits over long holding periods, so you can invest without worrying about stock market fluctuations or having to research individual companies. You can simply budget a certain amount and automatically invest it on a regular schedule, a practice known as dollar-cost averaging. Even if you do pick individual stocks, S&P 500 funds are a good foundation for your investment portfolio since you're guaranteed the returns of the stock market.

Three best S&P 500 index funds

These three major S&P 500 funds are extremely similar in composition since they all track the same index. All three exchange-traded funds (ETFs) -- a type of index fund -- invest in the 500 stocks that make up the S&P 500 index, and all have very closely replicated the index's performance:

Fund Name

Symbol

Expense Ratio

Total Fund Assets

Vanguard S&P 500 ETF

VOO

0.03%

$636.9 billion

iShares Core S&P 500 ETF

IVV

0.03%

$252.9 billion

SPDR S&P 500 ETF Trust

SPY

0.09%

$390.0 billion

Data sources: Vanguard , BlackRock  State Street Global Advisors . Data obtained on Feb. 11, 2021.

There are negligible differences between the performances of the S&P 500 index and each of these three funds that track it. The S&P 500 outperformed each fund slightly, as would be expected when accounting for each fund's expense ratio.

At the S&P 500's rate of return, a $10,000 investment five years ago would have grown by now to $23,610. As the table below shows, even the worst-performing index fund of the three would have increased that $10,000 investment to $23,540 today.

Index or Fund

1-Year Total Return

3-Year Annualized Return

5-Year Annualized Return

S&P 500 Index

17.25%

11.70%

16.16%

Vanguard S&P 500 ETF

17.11%

11.62%

16.13%

iShares Core S&P 500 ETF

17.22%

11.67%

16.12%

SPDR S&P 500 ETF Trust

17.08%

11.55%

15.98%

Data sources: Vanguard, BlackRock, State Street Global Advisors. Data obtained on Feb. 11, 2021, and is representative of each fund's performance as of Jan. 31, 2021.

With any of these three funds, you can expect your investment to deliver performance that's virtually identical to the S&P 500. The Vanguard and iShares options have the lowest expense ratios. However, if you're a fan of SPDR products, a 0.09% expense ratio isn't high by any means. A 0.09% expense ratio means that $0.90 of every $1,000 investment is annually collected as a management fee.

Beware of leveraged S&P 500 index funds

Be cautious of leveraged funds that are advertised as S&P 500 ETFs. Leveraged ETFs use borrowed money and/or derivative securities to amplify investment returns or to bet against the index. For example, a 2x-leveraged S&P 500 ETF aims to return twice the index's performance each day. So, if the index rises by 2%, the ETF's value rises by 4%. If the index falls by 3%, the ETF loses 6%.

These leveraged products are intended to be day-trading instruments and have an inherent downside bias over the long term. In other words, a 2x-leveraged S&P 500 ETF, over the long term, will not return twice the index's performance.

Investing in S&P 500 index funds is one of the safest ways to build wealth over time. But leveraged ETFs, even those that track the S&P 500, are highly risky and don't belong in a long-term portfolio.