Should You Buy This S&P Index Fund in 2011?

BALTIMORE (Stockpickr) -- While it's not uncommon to think of "the market" as a single unit, that hasn't always been the case. Even though stock market indices such as the S&P 500 and the Dow Jones Industrial Average have existed for decades, they were once more like sentiment indicators than the investible instruments that they are today.

That all changed when Vanguard founder Jack Bogle came to the realization that few mutual fund managers beat the broad market in the long-term. To combat that, in 1975 Bogle created the Vanguard 500 Index Fund (VFINX), the world's first index fund. Unlike traditional actively managed funds, the Vanguard 500 didn't seek to select the best investments in the world -- instead, it exactly mirrored the well-known S&P 500 index.

Although other fund managers thought that that index funds were a poor idea (the Vanguard 500 fund was originally referred to as "Bogle's Folly" and didn't initially raise enough capital even to buy all 500 of the S&P stocks), the result has been transformational to the investment world. Index funds are now one of the most prevalent mutual fund vehicles out there, and Bogle's once-mocked fund rings in as one of the biggest, with nearly $100 billion under management.

Related: 3 Investments That Could Rally in 2011

But times have changed. In 2011, we live in a world where ETFs, active trading strategies and individual stock picking have all gained popularity -- and longer-term investors remain shell-shocked from 2008's broad market selloff. The question remains: Does it make sense to buy S&P index funds in 2011?

Right now, I think that the answer is a resounding "yes" for a few reasons.

Concentrated Exposure to Attractive Assets

While index funds paint with broad strokes, right now index weightings are putting an emphasis on assets that look the most attractive right now. Unlike the price-weighted Dow, the S&P 500 is weighted by market capitalization. That means that larger companies make up a bigger portfolio concentration of the Vanguard 500 than smaller companies. That also means that a handful of dominant industries make up a larger part of the fund.

Right now, energy and industrial materials firms make up nearly a quarter of the fund, an attractive setup given the continuing commodity rally that we're currently in the midst of. Economic rebound performers such as consumer goods and telecom make up another 17%.

While financial services firms are the biggest single sector in the fund, at 15.7%, that exposure has been pared down from the highs of 2007, mitigating some of the biggest risks that remain in larger financial stocks. Likewise, weightings of sectors less prone to recovery in 2011 are smaller: Media firms make up only 3% of VFINX, and discretionary business services are only 3.15% of assets.

A Continuing Rally in 2011

The latter half of 2010 brought us a fairly powerful push higher as stocks reached highs not seen since September 2008. That rally is showing few signs of stopping -- at least in the first quarter of the new year. That's thanks in part to improved economic fundamentals and business performance, and in part to inflationary forces that look to bid up equities as corporate balance sheets trade at a discount to fair value.

From a fundamental perspective, companies are starting to look attractive on from a value perspective. That's financial performance has largely outpaced the rally in stocks.

To be fair, I'm not suggesting that we'll see new market highs in 2011 -- that prediction is far too speculative to make at this point in time. 2008 showed Main Street investors that markets can turn on a dime and quickly come out of step with fundamentals. That said, with technical indicators and economic data aligning investors and traders on the long side right now, we're entering 2011 under the right circumstances for higher stock prices.

Cheap Diversification

One of the primary draws of index funds is the low cost of investing in them. With an expense ratio of 0.18%, the Vanguard 500 Fund has consistently ranked as one of the cheapest S&P index funds on the market. Meanwhile, new offerings, such as the Vanguard S&P 500 ETF ( VOO), are providing investors with even cheaper alternatives (the ETF has an expense ratio of only 0.06%).

For that price, investors get exposure to a highly diversified portfolio of 504 stocks. The Vanguard 500's top 10 holdings only constitute around 10% of the portfolio's total assets -- a factor that means investors in the fund aren't susceptible to blowups in a single firm.

Ultimately, whether or not to invest in a fund like the Vanguard 500 depends largely on your investment objectives. If you're a week away from retirement or already have considerable stock holdings, you'll want to stay away. That said, if you're looking for a hands-off fund that's well positioned for mid- to long-term gains in 2011, the Vanguard 500 fund may be worth looking at.

To see the fund's top holdings, have a look at the Vanguard 500 Index Fund portfolio on Stockpickr.

-- Written by Jonas Elmerraji in Baltimore.

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At the time of publication, author had no positions in VFINX.

Jonas Elmerraji is the editor and portfolio manager of the Rhino Stock Report, a free investment advisory that returned 15% in 2008. He is a contributor to numerous financial outlets, including Forbes and Investopedia, and has been featured in Investor's Business Daily, in Consumer's Digest and on MSNBC.com.

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