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Finding the Best Fund for a Passive Allocation to U.S. Equities

We outline some of the key criteria in constructing a passive portfolio and discuss a framework for evaluating individual funds.

Michael Rawson, CFA, 10/24/2014

How many funds is enough? Vanguard Target Retirement 2055 VFFVX is a fund of funds that consists of just four funds: one for U.S stocks, U.S. bonds, international stocks, and international bonds. In contrast, MassMutual RetireSMART 2055 MMWAXhas 35 funds, of which 17 are focused on U.S. stocks. There is a separate fund for small-cap exposure, small-cap value, and small-cap growth. Which approach is better--a single fund to cover an entire asset class or separate funds that carve up and target specific segments of an asset class? A truly passive approach would seem to favor the former.

For taxable accounts, a broad index fund is a better option for investors building a complete allocation to U.S. equities compared with using separate size segment funds. Because a broad fund holds both large- and small-cap stocks, it is not forced to buy or sell as stocks migrate into a different market-cap range. For example, compare an investor holding a Russell 3000 Index fund versus separate funds for the Russell 1000 and Russell 2000 indexes. If a small-cap stock appreciates in price, it will be sold by the small-cap fund and purchased by the large-cap fund. But the Russell 3000 fund does not need to make any trades, as that same stock would just fluctuate up or down in size but stay in the same index. This low turnover can promote tax efficiency. Even for investors in tax-deferred accounts, holding a broad index fund should have lower trading costs. 

However, separate size segment funds may be viable for investors who prefer to more tightly control their allocation or give overweightings to certain segments of the market. Many investors maintain an overweighting to small-cap stocks. Here again, it can make sense for investors to hold most of their assets in a broad market fund. Based on Russell’s definition, a passive allocation to U.S. stocks would put about 93% of assets in the Russell 1000 and 7% of assets in the Russell 2000. Let’s assume that an investor wants to give an overweighting of 2% to small-cap stocks. Rather than holding 9% in a Russell 2000 Index, the investor could put 97.8% of assets in a Russell 3000 Index fund and 2.2% of assets in a Russell 2000 Index fund. In addition to being more efficient from a turnover perspective, in most cases this would also be lower cost because it puts fewer assets in the separate small-cap fund, which is typically higher cost. For example, SPDR Russell 3000 ETF THRK and SPDR Russell 1000 ONEK both charge 0.10%, while SPDR Russell 2000 TWOK charges 0.12%.

Expense Ratio
Fortunately, investors have lots of low-cost options. Russ Kinnel, Morningstar director of manager research, has found time and again that lower expense ratios tend to lead to better performance. This relationship is even stronger for index funds than it is for active funds. Generally, expensive broad market index funds can survive only when investors have limited choice, such as within a company 401(k) plan or within an insurance product.

Trading Costs
Exchange-traded fund expense ratio differences of only a few basis points can easily be trumped by trading costs. While Schwab US Broad Market ETF SCHB is the lowest-cost fund on our list, it is not the cheapest to trade. Trading costs become less important as the holding period increases. But they can be significant for frequent traders, such as those investing a small amount each month. Two good indicators of trading costs are assets under management and daily trading volume. Look for funds with at least $500 million that trade at least $5 million a day.

Tax Efficiency
Market-cap-weighted equity index funds tend to be more tax-efficient than active strategies because they tend to have low turnover. ETFs have an additional advantage over mutual funds that stems from their ability to rid themselves of low-cost-basis shares through the in-kind redemption mechanism. Look for funds with a long history and a large asset base, including both retail and institutional investors; they should be more tax-efficient. ETFs that have been less tax-efficient often have a small asset base, follow a niche strategy, have institutional clientele that rapidly left, or recently changed indexes.

Market Coverage
Most broad U.S. stock market indexes from major index providers such as S&P, Russell, MSCI, CRSP, and Dow Jones incorporate similar index construction techniques and tend to be highly correlated, but those that include more small caps and micro-caps have had better performance over the long term. Among the funds evaluated here, the S&P 1500 has the least complete coverage of small- and micro-cap stocks. In addition, this index is somewhat unique in that it still relies on a committee to pick stocks, rather than following a strict set of mechanical rules.

Picking the Best ETFs
This list really has no bad options, although I do have my favorites. I like Vanguard Total Stock Market ETF VTI because of its low expense ratio, low trading costs, tight tracking, broadest coverage, historical tax efficiency, and excellent stewardship from Vanguard. IShares Core S&P Total US Stock Market ITOT might be more appropriate for those who want to avoid some low-quality micro-cap stocks. The only funds I would be unlikely to use are iShares Dow Jones US IYY and SPDR Russell 3000 ETF THRK. Both have high trading costs, and THRK has a small asset base.  

Michael Rawson, CFA is an ETF Analyst with Morningstar.
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