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Home>Research & Insights>Fund Times>What Is Vanguard 500 Index's Achilles Heel?

What Is Vanguard 500 Index's Achilles Heel?

Market-cap-weighted indexes' greatest strength is arguably also their biggest weakness.

Adam McCullough, CFA, 08/05/2017

The following is our latest Fund Analyst Report for Vanguard 500 Index Fund VFINX

Vanguard 500 Index offers broadly representative and well-diversified exposure to U.S. large-cap stocks. This fund’s fee and a soundly constructed and reasonably representative portfolio leave it well-positioned to continue its long streak of generating attractive risk-adjusted returns relative to its peers over the long haul. It earns a Morningstar Analyst Rating of Gold.

Broad diversification is an intrinsic advantage of fund’s replication of the market-cap-weighted S&P 500, which covers approximately 80% of the investable U.S. stock market. An index committee manages the S&P 500’s composition, while most indexes follow mechanical, rules-based approaches. Yet, this index has performed similarly to other popular large-cap indexes, such as the Russell 1000 Index. Market-cap weighting pulls the portfolio toward the largest U.S. stocks and accurately reflects the composition of the market. Its market-cap-weighting approach can be beneficial in bull markets that are characterized by large-cap leadership, such as the post-financial-crisis charge in U.S. stocks. That said, market-cap weighting can also lead to 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 the fund’s broad market-cap-weighted approach. Lower turnover equates to lower costs and a lesser likelihood of taxable capital gains distributions. The average annual turnover the fund was 5% during the past five years. This compares to a median figure of 58% for its category peers. In fact, this fund hasn’t distributed a capital gain since its inception.

During the past decade through June 2017, this fund returned 7.2% annually, outpacing the U.S. large-blend Morningstar Category average by 1.5 percentage points. Much of this relative outperformance can be attributed to the fund’s sizable fee advantage. At 0.04%, the fund’s annual levy is a tiny fraction of the 0.90% median fee its category peers charge.

Process Pillar: Positive | Adam McCullough, CFA 07/31/2017
The fund employs full replication to track the S&P 500. This index effectively diversifies risk, promotes low turnover, and accurately represents its target market segment, supporting the Positive Process rating.

The S&P 500 has a slight quality tilt because of its conservative eligibility requirements. For instance, stocks must be profitable during the last four quarters before they are eligible to be added in the index. While qualifying stocks must pass some quantitative screens, a committee selects the final stocks for the index. And unlike other large-cap indexes, stock size is not the sole determinant of inclusion. Also, the index has higher free-float and trading volume requirements than similar indexes, which should help it avoid the least-liquid stocks. This committee structure gives the S&P 500 a greater degree of flexibility than indexes that follow more-mechanical rules, though this approach also reduces transparency.

Stocks are added and removed from the S&P 500 at the committee’s discretion, so it can be difficult to anticipate changes ahead of time. Because this is one of the most widely tracked indexes, changes tend to move stock prices. In January 2010, S&P announced Berkshire Hathaway would be added to the index, and Berkshire’s stock price appreciated more than 10% over the next few days.

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

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