Vanguard 500 Index Fund: Low-Cost, But Are There Better Alternatives?

By Jason HallFool.com

Getting the best return over time is key. Vanguard's low-cost funds can help. Source: Seniorliving.org

One of the simplest ways to invest, and get close to market-level returns, is with low-cost index funds. Of these kinds of funds, theVanguard 500 Index Fund, which tracks theS&P 500,is one of the best-known and one of the largest, trailing only theVanguard Total Stock Market Index Fundin total assets.

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In short, lots of people have decided, since they can't beat the market, they might as wellbethe market. Is that the right move for you? Furthermore, are there funds that follow other indices that offer better long-term potential? In short, there are other index funds -- as well as individual stocks -- that may be better-returning alternatives, but there's still a lot to like about the Vanguard 500 Index Fund.

Let's take a closer look at the fund itself (and the three share classes), as well as those alternatives.

Returns depend on which shares you ownVanguard has long been the stalwart in low-cost index investing, since it was first started by Jack Bogle in the 1970s, and the Vanguard 500 Index Fund was the first of its kind. And while it remains one of the lowest-cost funds, it's important to understand that there are actually three share classes within the fund, and depending on which shares you own, your returns will differ slightly:

On the surface it looks like the ETF is a no-brainer, right? The best answer is, "it depends" because it varies by how much you'll be able to invest up front, if the share class is even available to you (Admiral class shares aren't typically available in most brokerage accounts), and how often you plan to reinvest new money, due to the impact of trading fees, especially for the ETF (which is traded on a stock exchange).

Here's a look at how the expense ratio -- which is the annual cost Vanguard charges to run the fund -- alone has affected returns:

VFIAX Total Return Price data by YCharts

Since just after launching the ETF shares, you can see that the difference in the expense ratio has affected total returns, while the ETF shares have also been affected by the more volatile nature of its trading on a stock index. Over a longer period of time, this would likely normalize, since it has the same intrinsic value as the other share types.

Which share class is best?It's largely a product of how much you have to invest, where you are investing it -- i.e. 401(k) through your employer, a personal account with a discount broker, or directly with Vanguard -- and how much/how often you will invest new money.

For example, a fund balance of below $10,000 in either mutual fund share class will cost a $20 per year service fee, while there's no such fee for ETF shares. But you'll be subject your broker's commission rate if you buy ETF shares. As to the mutual fund shares, your broker may or may not even offer them for sale, limiting your options. The Admiral shares, as an example, are typically only available either directly through Vanguard, or through a Vanguard-managed relationship with your employer.

If you're planning to invest less than $10,000, that $20 annual fee makes the "effective" expense ratio much higher, so if you're not going to be able to get above that threshold, the ETF might be cheaper, unless you're planning to invest new money regularly. If you are, then trading commissions would end up costing a lot more than $20 per year. In short, if you have the $3,000 minimum to invest and plan to add more on a regular basis, the investor shares are probably the best bet. If you will start with less, or buy new shares only occasionally, the ETF shares would be cheapest as long as your trading fees don't break $20 per year.

Basically, figure out which share class will result in the least cost in fees and expenses based on how much you'll invest, and invest in that class.

Make it part of a diverse portfolioEven though theVanguard 500 Index Fundis already diversified with exposure to the 500 largest U.S. public companies, you will improve your chances of the best long-term returns by not putting all of your eggs in this one basket of stocks.

It's worth considering also investing in funds, like the iSharesRussell 1000 Growth Index ETF(NYSEMKT: IWF), adding exposure to more small companies, or theVanguard Growth ETF(NYSEMKT: VUG), (also available in mutual fund classes like the 500 Index Fund) which tracks the CRSP Large-Cap Growth Index -- a collection of almost 400 more growth-oriented businesses than the S&P 500:

VFIAX Total Return Price data by YCharts

Over the past several years, both of these funds have outperformed the 500 Index Fund, and there's a lot of evidence that exposure to more companies with growth potential, versus just the S&P 500 components, can improve long-term returns.

Furthermore, there's nothing wrong with investing a portion of your portfolio in index funds like these, while still investing in individual stocks. It will guarantee that you get market-level returns with at least a portion of your portfolio, while also trying to beat the market on your own. It's hard to beat the market -- most investors won't. But it's not impossible.

Either way, the Vanguard 500 Index Fund, after 40 years, remains one of the cheapest ways for the average investor to get market-level returns. If you're looking for a low-cost, simple way to track the market's returns, you could do worse.

The article Vanguard 500 Index Fund: Low-Cost, But Are There Better Alternatives? originally appeared on Fool.com.

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