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The Quintessential U.S. Equity ETF

This Vanguard offering is one of the cheapest and most diverse domestic-equity funds available, making it an ideal core holding, writes Morningstar analyst Mike Rawson. 

Michael Rawson, CFA, 09/25/2013

Vanguard Total Stock Market VTI is our favorite equity exchange-traded fund for passive exposure to the U.S. stock market, as it provides the broadest possible exposure for the incredibly low cost of 0.05%, or $5 for every $10,000 invested. While SPDR S&P 500 SPY may attract more trading volume, it is not the best choice for broad exposure to the U.S. market. Because large-cap stocks dominate the S&P 500 Index, SPY does not include most mid-caps or any small-cap and micro-cap stocks. In contrast, VTI invests in most liquid U.S. stocks, sweeping in more than 3,500 holdings across the market-cap spectrum. Over the long run, small-cap stocks tend to outperform their larger counterparts. This may partially explain why VTI has generated a slightly higher annualized return during the past 10 years (8.04%) than SPY (7.23%).  

VTI has about $35 billion in assets, less than a quarter of SPY's $150 billion in assets. But as a separate share class of the Gold-rated Vanguard Total Stock Market Index VITSX mutual fund, VTI is part of a $262 billion pool of assets. This large scale spreads fixed costs over more assets and helps to improve efficiency. During the past decade, VTI matched its index almost perfectly, while SPY lagged by 0.11%. SPY is also prohibited from engaging in securities lending, a strategy VTI uses conservatively to offset shareholder expenses. 

Holding a total-market index fund is more efficient than holding separate funds for large-cap and small-cap exposure because the broad fund requires 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, as well as for active investors who wish to follow a core-and-explore approach.

Few equity funds are as diversified as VTI. While this diversification mitigates stock-specific risk, it cannot eliminate the risk of the market itself. For example, the fund had a standard deviation of 15.3% over the past 10 years compared with 14.7% for the S&P 500. The higher risk of VTI is due to the inclusion of more-volatile small-cap stocks. The best way to reduce the risk of VTI further would be to pair it with a high-quality bond fund.

Fundamental View
Since the end of the most recent recession in June 2009, real GDP growth has averaged about 2%. This is below the post-World War II average growth rate of 3%. While a 1% difference in growth may not seem catastrophic, if it continues, it will have a negative impact on earnings growth. It is also disappointing when considering that periods following a recession typically experience above-average growth rates. This slower growth is reflective of a "new normal" economy that can be characterized by lower expected rates of return. 

Despite the slower growth, the recovery has been supportive of corporate earnings, which in turn has supported equity markets. The S&P 500 Index rallied by 16% in 2012 and an additional 20% through September 2013. This market appreciation has gotten ahead of the growth in earnings, causing the market to appear expensive. For example, the Shiller P/E, which is the ratio of price/average 10-year earnings, is at 24.0, well above its long-term average of 16.5.

Morningstar equity analysts cover stocks that represent 85% of assets in the U.S. equity market. They build detailed cash flow projections and assign a price/fair value estimate for each stock that they cover. These estimates can then be aggregated to the index level. In mid-September, they see the market trading at a price/fair value of 1.00, which is fairly valued. 

The Federal Reserve has pledged to keep the federal-funds rate low until the unemployment rate falls to 6.5%. This has resulted in lower long-term rates for Treasury bonds as well as riskier fixed-income securities, such as corporate and high-yield bonds. However, the Fed has signaled a desire to slow its rate of bond purchases, which helps to lower long-term rates. As a consequence, the yield on the 10-year U.S. Treasury note has increased to about 2.7%. This puts it above the market dividend yield of about 2.0% for the first time in a couple of years. As bonds become more attractive relative to stocks, money likely will flow to bonds and stock returns could be constrained.

Michael Rawson, CFA is an ETF Analyst with Morningstar.
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