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This ETF and the S&P 500 Make a Good Pair

Consider this low-cost exchange-traded fund to round out a large-cap equity holding.

Adam McCullough, CFA, 05/15/2017

Vanguard Extended Market ETF VXF invests in nearly all U.S. stocks outside of the S&P 500. It efficiently tracks a well-diversified market-cap-weighted index at a low fee, which supports its Morningstar Analyst Rating of Gold.

The fund tracks the S&P Completion Index, which is designed to round out a large-cap equity holding, such as an index fund tracking the S&P 500. The fund primarily holds mid-, small-, and micro-cap stocks, but it also includes a handful of large-cap names. The fund lands in mid-blend territory, but it reaches further down the market-cap spectrum than most peers and straddles the mid- and small-cap size segment breakpoint. Indeed, small- and micro-cap stocks make up over 50% of its holdings by weight. Because the index relies on others to accurately price its holdings, the fund is fully exposed to the potential excesses of the market. But it also reflects the collective views of active investors.

The fund uses representative sampling to effectively track its underlying index and mitigate transaction costs because smaller, less liquid stocks are usually more expensive to trade than large-cap stocks. Its broad market-cap-weighted portfolio promotes low turnover. Each stock's weighting in the index naturally moves with its price. Turnover has averaged 12% over the trailing 10 years, a fraction of the average among its Morningstar Category peers. Low turnover and efficient tracking have paid off from a tax perspective. This fund has not issued a capital gain over the past decade.

For the trailing 10 years through April 2017, the fund performed well, topping the mid-cap blend category average by 1.5 percentage points each year with slightly more volatility. Its Sharpe ratio (a measure of risk-adjusted performance) landed in the top third of its peer group over the past decade. Its cost advantage and greater exposure to small- and micro-cap stocks were the biggest contributors to its outperformance.

Fundamental View
Indexing offers investors an efficient exposure to stocks. This is because market participants quickly incorporate new information into the stock prices that indexes use to weight their holdings, effectively free-riding active investors' price-discovery process. Furthermore, given advances in information technology and the growth in the portion of investable assets that is managed by skilled professional investment managers, the market has arguably become more efficient over time, making it harder for active managers to consistently outperform. But market efficiency alone does not explain the long-term success of broadly diversified market-cap-weighted index funds.

The second leg of the investment thesis for index funds is their cost advantage. Index funds are cheaper to manage than actively managed alternatives. Their sponsors don't have to pay portfolio managers and investment analysts to identify under- or overvalued stocks to be added to or sold from their portfolios. Also, market-cap-weighted index funds have lower turnover relative to actively managed funds. Turnover has a price. Trading costs contribute to the headwinds facing active strategies, and higher-turnover actively managed funds will regularly distribute taxable capital gains to their shareholders. This creates an additional drag on performance when these funds are held in taxable accounts. Taken together, these costs are the largest and most persistent drag on the performance of actively managed strategies.

Market-cap-weighted indexes like the S&P Completion Index have some noteworthy drawbacks. By owning "the market," investors are relying on other market participants to price stocks on their behalf. While over long stretches of time, market participants have done a good job of valuing stocks, these long horizons have been marked by episodes of mania and panic. The mania most often cited as an example of the drawbacks of owning indexes like the S&P 500 outright is the technology bubble, when technology stocks accounted for nearly one third of the index's market cap. Episodes like this are unavoidable for index investors and create opportunities that have historically been exploited by (some) active managers.

This is a well-diversified portfolio that straddles the mid- and small-cap size segments. Its average market capitalization is less than half the mid-cap blend category average because it owns small- and micro-cap stocks. Indeed, over 50% of its assets are invested in small- and micro-cap stocks. Likely because the fund owns smaller stocks, its return on equity is consistently below the category average's. Its top 10 holdings represent less than 5% of its holdings, while the mid-cap blend category averages over 20%. Top holdings include large-cap stocks just outside the S&P 500, such as Tesla TSLA and  Las Vegas Sands LVS.

Adam McCullough, CFA, is an analyst on Morningstar’s manager research team, covering passive strategies.

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