If you were going to build an entire portfolio around one ETF, which would it be?
Vanguard Total Stock Market
Holding a total market index fund is more efficient than holding separate funds for large-cap and small-cap exposure because the broad fund has to incur less turnover as stocks move up and down in size. VTI is an ideal fund for passive investors who believe in the benefits of index investing and for active investors who wish to follow a core-and-explore approach.
Few equity funds are as diversified as VTI is, but that does not mean that the fund is without risk. Diversification reduces your nonmarket risk, but it can not eliminate the risk of the market itself. For example, the fund had a standard deviation of 15.7% over the past 10 years compared with 15.2% for the S&P 500. The higher risk of VTI is due to the inclusion of higher-risk small-cap stocks. The best way to reduce the risk of VTI further would be to pair the fund with a high-quality bond fund.
The equity market has rallied sharply in 2012 and stocks no longer sell at the attractive valuations we saw during periods when the European debt crisis sapped investor confidence. Morningstar equity analysts cover more than 900 stocks in this fund and 88% of the assets. They develop discounted cash flow models for each stock that they cover allowing them to establish fair value price targets which can then be aggregated up to the fund level. Our analysts see this ETF as trading at a price/fair value of 0.94. This is not nearly as attractive as it was at the start of the year, when it sold for a price/fair value of 0.87.
While the U.S. economy has seen improvement in employment and in key sectors such as auto and homebuilding, earnings growth has slowed. While earnings growth is expected to be flat at the end of 2012, growth is expected to pick up in 2013 to about 10%. But consumer confidence could be pressured by political uncertainty ahead of the fiscal cliff. If congress fails to act, the Congressional Budget Office has forecast a recession for next year. It is difficult to imagine earnings growth of 10% if we do enter a recession. On the positive side, the Federal Reserve has aggressively pursued lower interest rates in hopes of spurring the economy. Mortgage interest rates are at record lows, and corporations have shown a willingness to borrow. Still, long term valuation measures such as the Shiller PE are flashing caution signs. In light of these uncertainties, we feel it is appropriate to remain conservative with your equity allocation or perhaps trim any overweighting to equities.
Vanguard Total Stock Market currently follows the MSCI US Broad Market Stock Index, which encompasses all but the most illiquid U.S. stocks. Vanguard plans to switch to a similar index provided by CRSP. While this will be a new index, CRSP has vast experience in providing index and pricing data as it was founded in the 1960s by researchers at the University of Chicago. CRSP incorporates all of the latest indexing technology including using a packeting approach to reduce the frictions when a securities hovers around a market cap breakpoint. The index switch should not have a significant impact on the performance of the fund and the decision to switch indexes is being driven primarily by lower index licensing costs rather than differences in the indexes. As a total market index, it holds large-, mid-, small-, and all but the most illiquid micro-cap stocks. The fund follows a representative sampling approach, but due to its size, it is able to hold almost all of the securities in the index at nearly identical weightings.
The fund charges just 0.06%, which is one of the cheapest total stock market funds available. While Schwab offers a broad market fund for only 0.04%, VTI is not only more comprehensive, but it has beaten Schwab U.S. Broad Market
The aforementioned SCHB is probably the best alternative for VTI, particularly for investors on the Schwab platform. SCHB tracks an index that holds 2,500 securities, so it excludes micro-cap stocks. Also, SCHB engages in more liberal sampling of its index while VTI is closer to full replication. Compared with SCHB, large-dollar investors will find better liquidity in iShares Russell 3000