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IN 1774, AMSTERDAM businessman Abraham van Ketwich created a new type of investment. After raising money from a group of individuals, van Ketwich built a portfolio of bonds. He deposited the bonds in a metal box in his office, which three people then secured using three different locks.
Van Ketwich’s fund could be considered the world’s first index fund. How so? For starters, the bonds purchased were broadly diversified across industries and geography. Second, van Ketwich’s plan aimed to minimize trading, with the box remaining locked for 25 years. Third, his management fee was just 0.2%, modest even by today’s standards. A war in Europe disrupted the plan a bit. But in the end, the fund was successful, and others soon followed using this same model.
The first modern index funds started in the U.S. in the 1970s, and initially were very simple. But in the years since, there’s been a proliferation of funds. Now, there are more than 2,000 different index funds covering every corner of domestic and international markets. This poses a challenge for today’s investor because there’s no single, universally accepted “right” way to build a passive investment portfolio.
Consider a portfolio that’s invested entirely in an S&P 500 index fund. By most definitions, this would be considered a passive portfolio. But even this simple portfolio is active in at least two respects: The S&P 500 focuses almost exclusively on the largest U.S. companies, and it includes almost no companies from outside the U.S.
The reality is that every investment portfolio, even if it consists solely of index funds, has an active component to it. And while it may sound like I’m splitting hairs, the reality is that those who consider themselves passive investors still need to make some active decisions.
If you’re building an index fund portfolio, there are three approaches you might consider. The first option would be to cast as wide a net as possible. An index like the FTSE Global All Cap Index—as its name suggests—tries to cover the globe. The U.S. and Canada account for about two-thirds of this index, with the remainder allocated to developed and emerging markets outside North America. A popular fund that follows this index is Vanguard Group’s Total World Stock ETF (symbol: VT).
True indexing purists like this fund because it aims to provide global coverage, though in reality it doesn’t cover the entire globe. It excludes dozens of markets, from Argentina to Romania to Slovenia, which are in a category known as frontier markets. But aside from that, it’s as broad an index as there is.
This fund certainly offers simplicity, but are there downsides? From a domestic investor’s point of view, exchange rates pose a risk, since a third or so of the investments aren’t denominated in dollars. For that reason, I prefer to minimize international exposure. But others see it differently. They see exchange rates as an additional source of diversification.
Another potential downside: To the extent that the U.S. economy has a track record of producing more new, fast-growing companies than other countries, a portfolio like this might end up lagging behind one that’s more U.S.-focused.
If you wanted more of a domestic weighting, there’s an easy solution. That brings me to the second approach: You could split your portfolio along geographic lines, owning one fund that covers the U.S. market and another covering international markets. You could then vary the mix between the two. If you wanted to go this route, two funds to consider would be Vanguard’s total domestic stock market fund (VTI) and its total international fund (VXUS).
What percentages make sense? I’ve long relied on research which finds that investors can pick up most of the diversification benefit of international stocks with an allocation as small as 20%. Thus, my preferred allocation to international stocks is just 20%. It’s a matter of perspective, though, and there isn’t one right answer.
The third major approach to portfolio construction might appeal to those looking for greater customization. On the domestic side, a popular strategy includes greater exposure to value stocks. According to the data, these stocks have outperformed historically. But since that trend may not repeat in the future, value stocks may or may not appeal to you. Personally, I include an overweight to value.
On the international side, there’s a number of ways to customize your holdings. Investors will often choose separate developed and emerging markets funds so they can vary the mix between them.
In the portfolios I build, emerging markets are always the smallest segment. But ironically, I’ve found it to be the area where there’s the most disagreement. Some investors prefer not to hold any emerging markets stocks, owing to the shaky political structures in many of those countries. Meanwhile, others prefer to have more emerging markets exposure. The logic they cite is that these countries offer more growth potential as they industrialize.
I take a different route, avoiding standard emerging markets indexes altogether. Why? The most recent Nobel prize in economics was awarded to a group of researchers who identified a link between countries’ political structures and their level of economic development. In short, countries with autocratic governments have generally not delivered the same level of economic growth as countries with more democratic regimes. Because China, which lacks representative government, is the largest weight in standard emerging markets funds, I’ve opted for a fund (FRDM) which excludes China and other dictatorial regimes, and instead includes only emerging markets where the political institutions are more developed.
Those are three approaches you might choose in constructing an index fund portfolio. But there isn’t, as I said, just one right way. What’s most important, in my view, is to be sure the portfolio you build adheres to two key principles: low cost and low turnover.
Low fees are important because, as Vanguard founder Jack Bogle used to say, “You get what you don’t pay for.” In other words, when a fund has low expenses, those savings are passed on to the investor. That’s a key reason—and maybe the key reason—index funds have, on average, outperformed actively managed funds.
What about low turnover? I’m referring here to how much trading occurs within a fund. This is important—because more frequent trading generally results in higher tax bills for a fund’s investors.
Adam M. Grossman is the founder of Mayport, a fixed-fee wealth management firm. Sign up for Adam’s Daily Ideas email, follow him on X @AdamMGrossman and check out his earlier articles.
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I’m just curious, what % of your portfolio is value? Or how do you think about the over-weight position in value? And what’s your turnover threshold to rule out an index? How do you like to evaluate that? Nice article. Thank you.
Just looked at the history of FRDM. If you’d invested on Biden’s inauguration day and sold on Trump’s most recent inauguration day, you’d have a about a one penny …that’s right one red cent… profit/loss in 4 full years. I didn’t check any distributions during that time; just FRDM’s price.
Jonathan Clements and William Bernstein,among others, recommend an agnostic world market cap equity weighting with a value tilt. But this statement of yours caught my eye:
“In short, countries with autocratic governments have generally not delivered the same level of economic growth as countries with more democratic regimes.”
If you believe in this I assume you’re rapidly divesting yourself of US stocks given the reality of what we have become.
See Scott Dailey below. Doesn’t holding large global American corporations give you plenty of exposure to foreign, usually stable, markets?
That was John Bogel’s reasoning, and thus why he didn’t believe investing in foreign stock was necessary.
He was also vehemently against ETFs. His biggest complaint was that, with him believing in low turnover portfolio to minimize investment costs, the format would lead investors to trade excessively and thus decrease their returns. I don’t believe that in my copious investment reading I have seen a research paper confirming this theory.
Anyways it’s ironic that Vanguard was in the vanguard of ETF offerings. If he was at the “helm” of Vanguard when this type of investing became a reality his company would not have anywhere the assets under management that they have today.
Instead of a value fund, and to eliminate the biggest tech companies, I like SCHD.
Is there an index fund that invests exclusively in corporations formally registered in democratic foreign countries?
I ask because of this point in your article:
“The most recent Nobel prize in economics was awarded to a group of researchers who identified a link between countries’ political structures and their level of economic development. In short, countries with autocratic governments have generally not delivered the same level of economic growth as countries with more democratic regimes.”
Thanks Adam. Not unexpectedly well-reasoned. There’s no single right answer, and in particular I really liked how you explained why some may choose an index leaning more strongly towards large US companies, given what has largely been a nearly 75 year boom post WW2. Tough to argue on a macro level that, unlike the case pre WW2 (so, including the great depression), that the US has emerged as the singular superpower. This may change in the next century with China, but that story is yet to be written.
True that S&P 500 companies are US based, but also true that they do business around the globe. I’m guesstimating that 1/3 of their revenues, on average, are foreign.
Thank you Adam for once again, for another “reminder” article for most HD readers but an enlightening article that we can share with others
To minimize expenses even further would it not be better to invest in Vanguard Total Stock and Vanguard International stock rather than Vanguard World Stock? Maybe its splitting hairs but as Jack said ” you get what you don’t pay for”.
This is what would be recommended if an investor wants to target a specific allocation to foreign stocks different from Vanguard Total World’s (currently 36%) as it would allow for more closely maintaining the desired allocation by selling of the more appreciated assets and buying the alternative fund.
Thank you for reminding us that there are many reasonable paths we might choose. I like simplicity, but I am a fan of the saying attributed to Einstein: “make everything as simple as possible but no simpler”. I own domestic, international and emerging market stock index funds, but prefer to adjust the relative proportions myself. And I share your preference for FRDM over funds investing in standard indexes. Nice review, Adam.
The international diversification question has always perplexed me. I’m a huge fan of Jack Bogle, who felt that international holdings were not necessary due to the expansive international presence of US companies. Yet, many say it is necessary and right now is definitely helping. But, looking back over long-term periods….20 to 50 years, the US has crushed International. So what to do?
Of any time in my investing life (I’m 67) this is definitely the time to be invested internationally. With the direction things are currently headed one who is totally invested in US stocks will not be investing in the same stable country we have since WW II.
Int’l funds can benefit both portfolio diversification and portfolio yield.
Over the last 125 years, the U.S. share of global market cap has swung widely: low before WW II, dipping from 1970s inflation and during Japan’s 1980s go-go years, rising and falling with the dot com boom/bust, then rising again with the AI boom.
If U.S. stocks were sure to “crush” international stocks, wouldn’t the price of U.S. stocks be bid up to eliminate the performance advantage?
If foreign stocks offered no diversification benefit, wouldn’t they perform in lockstep with U.S. shares?
My portfolio does include sector ETFs, which is what I consider FRDM to be. What I like about that approach is the ability to enhance a group of companies in the portfolio, while reducing the exposure to others. In VTI there are more than 3600 companies represented but 10 of those companies represent 30% of the assets. As an example, perhaps I don’t want quite so large a stake in Apple, Microsoft, Nvidia and Amazon. This is particularly true for me when people pile into certain companies, or if I own individual stocks as well as indexes, and I do.
So which index would meet your criteria of not large stake in certain companies
Thanks, Adam, for the historical background. Van Ketwich’s ability to attract investors with a 25-year “lock box” is fascinating considering that average life expectency of the wealthier folks in his circle would likely have been in the 50s. Would love to know how he pitched the investment and how the investors viewed the benefits.
According to this interesting article, the average age of death for elite European males at this time was 56, but of course, since it was an average, some would have lived longer. Plus, they may have been investing for their heirs.
I think the key issue most investors must overcome is their own behavior. That is, the temptation to tinker, trading in and out of positions and allocations based on changing attitudes and recent performance of various slices of their portfolio.
Indexing is a good way to overcome this, but setting our asset allocation and sticking to it is equally as important. The indexer who constantly shifts their asset allocation based on recent performance or new research is no better off than the active investor who holds tight and does nothing.
Thank you for good, solid investment advice.
Thank you for sharing your thoughts. There are many ways to skin this cat but I am very much in the camp of keeping costs low and turnover minimal. I prefer the ETF camp over mutual funds and to keep the portfolio as simple as possible.
My line-up is 55% SPY, 20% VEU, 20% BND, and 5% Cash and I use the 70/30 ratio as my comparative baseline – If I stay ahead of the 70/30 in the 1,3,5, and 10 years I am satisfied.
Richard, I’ve never seen a 70/30 baseline category for fund comparisons. What service do you use to get your 70/30 baseline numbers?
“…when a fund has low expenses, those savings are passed on to the investor.”
Morningstar research has also shown that in general that the lowest fee funds have the highest returns, no matter the investment category.