Ask ii: what is the best way to invest passively in the US stock market?

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I've heard about the strong average annual returns generated by the S&P 500 index over the past 100 years. I want to invest regularly in a US tracker fund, but there are lots to choose from. Which one should I buy?

Kyle Caldwell, deputy collectives editor at interactive investor (pictured above), says: The US stock market is the biggest in the world, and as you’ve mentioned it has historically delivered strong returns to investors. Research by London Business School and Credit Suisse shows that over the past 123 years, US shares have delivered a real return (inflation adjusted) of 6.4% a year. This is higher than UK shares, which have returned 5.3% on average.

The simplest and cheapest way of gaining exposure to the US stock market is through an index fund or exchange-traded fund (ETF). Both ‘buy the market’ and their returns will mirror how the index performs, minus fees. For passive funds, it is important to size up the fund charge, particularly when different charges are being levied for tracking the same index.

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Before we get to the ETF options for the US market, lets first cover currency. With an ETF, you may see both a sterling and a dollar share class. Most UK investors will opt for the sterling share class (if it is available) to avoid foreign exchange costs.  

In addition, in terms of performance, the share class picked will not make a difference to overall total returns. For a US ETF, the underlying assets will be valued in dollars in both cases, whether you’ve picked the sterling share class or the dollar share class.

The two most-popular US exchanges that private investors own are the S&P 500, which is a basket of the 500 largest, most profitable businesses in America, and the Nasdaq, an exchange favoured by technology companies, but which also hosts plenty of healthcare, industrial and consumer-focused firms as well.

There’s also the Dow Jones index, but this is much less popular with passive investors. This is due to it tracking a small number of stocks (just 30), and using a price-weighting methodology. With this approach, company size is not taken into account. Instead, it is simply the stocks with the highest share prices that have the biggest influence on the performance of the index.

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Most major indices, such as the FTSE 100 and S&P 500, all use market-cap weightings, which rank companies by their size.

As a result, there’s not many options to track the Dow Jones, and the fees are higher than tracking the S&P 500. One option is the iShares Dow Jones Indust Avg ETF USD Acc USD (LSE:CIND), which costs 0.33% a year. There's no sterling class available on interactive investor. 

Gaining exposure to the S&P 500 is much cheaper, while also offering much more diversification in terms of sectors and the number of holdings.

Both the Vanguard S&P 500 UCITS ETF GBP (LSE:VUSA) and the iShares Core S&P 500 ETF USD Acc GBP (LSE:CSP1) charge just 0.07%. This works out at £7 on a £10,000 investment.

As would be expected, the same stocks are held, with the biggest positions being: Apple (NASDAQ:AAPL), Microsoft (NASDAQ:MSFT), Amazon (NASDAQ:AMZN), NVIDIA (NASDAQ:NVDA), Alphabet (NASDAQ:GOOGL),Tesla (NASDAQ:TSLA), Berkshire Hathaway (NYSE:BRK.B), Meta Platforms (NASDAQ:META), Exxon Mobil (NYSE:XOM), and UnitedHealth Group Inc (NYSE:UNH).

The performance is virtually identical. According to FE Fundinfo, over three years the iShares Core S&P 500 ETF USD Acc GBP is up 50.2% versus 50.1% for the Vanguard S&P 500 UCITS ETF GBP.

However, while the Vanguard and iShares ETFs regularly appear towards the top of the monthly table of most-bought ETFs among interractive investor customers, the cheapest option for the S&P 500 is the Invesco S&P 500 ETF (LSE:SPXS), costing 0.05%. The returns are slightly higher, at 51.1%.  

The Invesco ETF is synthetic. This means it does not own the shares in the index, instead replicating the return of the index through a counterparty (a bank). Most ETFs adopt the other approach – physical replication – through buying the shares of the index they aim to mirror.

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Alongside the S&P 500, another favourite index of investors is the Nasdaq, which is a tech-heavy index. The Nasdaq Composite includes more than 3,000 stocks on the Nasdaq exchange, while the Nasdaq 100 includes 100.

While investors are likely to see the Nasdaq Composite most frequently cited in the news, most ETFs available to UK investors mirror the Nasdaq 100. These include the Invesco EQQQ NASDAQ-100 ETF GBP (LSE:EQQQ), and the Invesco EQQQ NASDAQ-100 ETF GBP (LSE:EQQQ). The annual charges are 0.30% and 0.33%.

Outside the three most famous stock markets there are other exchanges, including the MSCI USA index, which is used by some ETFs. The cheapest ETF tracking this index is the synthetic Invesco MSCI USA ETF (LSE:MXUS), which costs 0.05%. Other options include the Xtrackers MSCI USA ETF 1C GBP (LSE:XDUS) and iShares MSCI USA ETF USD Acc GBP (LSE:CU1). The respective charges are vastly different, 0.07% and 0.33% respectively.    

The MSCI USA index tracks 626 stocks, investing in large- and mid-cap shares. As a result, it has greater exposure to mid-caps than the S&P 500.

An index that offers even greater diversification is the S&P Total Market Index. This comprises more than 4,000 constituents including large, mid, small and micro-cap stocks. An index fund mirroring this index, which is a member of interactive investor’s Super 60 list of investment ideas, is Vanguard U.S. Eq Idx £ Acc. It costs 0.1% a year.

For investors looking for US smaller company exposure, options include the SPDR® Russell 2000 US Small Cap ETF GBP (LSE:R2SC) or the Xtrackers Russell 2000 ETF 1C GBP (LSE:XRSG), which cost 0.30% and 0.32% respectively.  

Active funds, those managed by professional investors, are another option to consider. However, due to the US market being the most widely researched and followed, it is notoriously difficult for fund managers to consistently gain an edge. Data shows that over the past decade only around 5% to 10% of active funds outperformed the US stock market.      

However, not all US active funds should be written off. Our Super 60 list contains three active options: Jupiter Merian North American Equity, Artemis US Smaller Companies, and Premier Miton US Opportunities.