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The World's Largest Fund Just Got a Bit Cheaper

It is hard not to like this fund, especially following another fee cut.

Ben Johnson, 05/19/2017

Vanguard Total Stock Market ETF VTI offers investors diversified exposure to the U.S. stock market. A low fee and a soundly constructed and reasonably representative benchmark leave this exchange-traded fund well-positioned to continue its long streak of producing superior risk-adjusted returns relative to its large-blend Morningstar Category peers over the long haul and underpin its Morningstar Analyst Rating of Gold.

During the 20-year period ended April 30, 2017, the Admiral share class of the Vanguard Total Stock Market Index fund (used as a proxy here given that VTI's inception was in May 2001) returned 8.01% per year, outstripping the U.S. large-blend average by 1.61 percentage points per year. Much of this relative outperformance can be attributed to the fund’s sizable fee advantage. At 0.04%, VTI’s annual levy is a tiny fraction of the 0.90% median fee charged by its peers in the large-blend category.

Broad diversification is an intrinsic advantage of funds tracking market-capitalization-weighted total stock market indexes, which capture nearly the entirety of the investable market capitalization of the U.S. equity market. However, market-cap weighting has its pluses and minuses. It can be a beneficial approach in momentum-driven bull markets that are characterized by large-cap leadership, such as the post-financial-crisis charge in U.S. stocks. But it can also lead to significant sector and single-security concentration, as witnessed at the height of the technology bubble. So market-cap-weighted indexes’ greatest strength is arguably also their Achilles’ heel.

Low turnover is another key advantage of a fund tied to a cap-weighted benchmark. Lower turnover equates to lower costs and a lesser likelihood of taxable capital gains distributions. VTI’s median annual turnover was 10% during the trailing 10-year period. This compares with a median figure of 66% for its category peers.

While VTI possesses a sizable fee advantage, there is a pair of less-expensive options available for long-term investors. Many might be marginally better off investing in the lowest-cost options of all, iShares Core S&P Total US Stock Market ITOT or Schwab US Broad Market ETF SCHB, both of which charge an annual fee of 0.03%.

Fundamental View
In their history, broadly diversified market-cap-weighted indexes have proved a difficult hurdle for many U.S. large-cap managers to clear. The first S&P 500 fund, Vanguard 500 Index VFINX, was launched 40 years ago. Few actively managed U.S. large-cap stock funds that were around in 1976 are still in existence today. Fewer still managed to produce better returns than Vanguard 500 Index during the past four decades.

Many attribute active managers' collective struggles to best index funds to the overall level of efficiency of the market for U.S. large-cap stocks. Efficiency in this case is meant to indicate the speed and precision with which market participants incorporate new information into stock prices. Furthermore, given advances in information technology and the growth in the portion of investable assets that is managed by an increasingly skilled set of professional investment managers, it can be argued that the market has become ever more efficient over time. 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 less expensive to manage than actively managed alternatives. Their sponsors don't have to pay teams of 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. Commissions, bid-ask spreads, and market-impact costs all add to the headwinds facing active strategies. Also, turnover has tax implications. Higher-turnover actively managed funds will regularly distribute taxable capital gains to their shareholders. This creates an additional drag on these funds’ performance in the case where they 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 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 cap-weighted indexes was the technology bubble, when tech stocks accounted for nearly one third of the S&P 500's market cap. Episodes like this are unavoidable for index investors and create opportunities that have historically been exploited by (some) active managers.

Portfolio Construction
This ETF tracks the CRSP U.S. Total Market Index, which holds almost every liquid U.S. stock. It includes all stocks with a primary listing on a major U.S. stock exchange, incorporated or with a major business presence in the United States, with a market cap of at least $10 million, with at least 10% of shares publicly available, and meeting minimum trading requirements. This results in an average market cap for stocks in the index that is less than half the typical fund in the category. The fund employs full replication for the largest 1,200 or so stocks in its portfolio--owning each in their corresponding index weightings--and then samples from the remaining smaller-cap stocks. However, this fund’s large asset base allows it to replicate the index better than most other total market funds. The resulting portfolio consists of approximately 3,600 holdings, about the same as the index. The fund has historically used securities lending to generate additional income in an effort to improve tracking performance. It is worth noting that this fund has twice changed its benchmark index since its May 2001 inception. Up until April 2005, it tracked the Dow Jones U.S. Total Stock Market Index (formerly the Dow Jones Wilshire 5000 Index). From April 2005 until June 2013, it followed the MSCI U.S. Broad Market Index. These changes were largely immaterial. The most recent change was driven by Vanguard’s desire to reduce index licensing fees.

The fees for the ETF and Admiral share classes of this fund were recently reduced to 0.04% from 0.05%, a small fraction of the 0.90% median levy taken by its peers in the large-blend category, meriting a Positive Price rating. During the five-year period ended April 30, 2017, the fund lagged its spliced index by 2 basis points annualized, implying it had offset some of the drag created by its fee through a combination of portfolio management techniques and securities lending.

Gold-rated Schwab US Broad Market ETF SCHB has a lower stated expense ratio at only 0.03%. However, the fund’s portfolio is somewhat narrower, given that its bogy targets 2,500 stocks. As a result, it excludes most of the micro-caps that are constituents of VTI’s benchmark. That said, the market-cap coverage between the two is substantially similar. Following a benchmark change in December 2015 and a recent fee reduction, ITOT is arguably VTI’s most formidable direct competitor. ITOT charges an annual fee of 0.03% and carries a Morningstar Analyst Rating of Gold. It follows the S&P Total Market Index, which is similarly broad as the CRSP index underlying VTI. Both funds have a comparable number of holdings and near-identical exposure from top to bottom down the market-cap spectrum.

For those who want to avoid overlap with existing holdings in large-cap stocks or funds, Gold-rated Vanguard Extended Market ETF VXF might be worth considering. The fund tracks an index that captures all those stocks that aren’t included in the S&P 500. It charges a very competitive fee of 0.08%.


Disclosure: Morningstar, Inc. licenses indexes to financial institutions as the tracking indexes for investable products, such as exchange-traded funds, sponsored by the financial institution. The license fee for such use is paid by the sponsoring financial institution based mainly on the total assets of the investable product. Please click here for a list of investable products that track or have tracked a Morningstar index. Neither Morningstar, Inc. nor its investment management division markets, sells, or makes any representations regarding the advisability of investing in any investable product that tracks a Morningstar index.



Ben Johnson is Morningstar’s Director of European ETF Research.

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