Our Favorite U.S.-Equity ETF

 Vanguard Total Stock Market (VTI) is the quintessential ETF, providing the broadest possible exposure to the entire U.S. stock market for the incredibly low cost of merely 0.06%. While  SPDR S&P 500 (SPY) may attract more attention and assets, it is not the best choice for pure beta exposure to the U.S. market. Holding just the top 500 stocks, it does not include most mid-caps or any small-cap or micro-cap stocks. On the other hand, VTI holds more than 3,300 stocks. Because of the tendency for small-cap stocks to outperform over long periods of time, VTI has returned 8.73% per year over the past 10 years, beating the 7.91% of SPY. In terms of tracking efficiency, VTI lagged its index by only 0.03%, less than its 0.06% expense ratio, while SPY lagged by 0.14%, more than its expense ratio. These are some of the reasons why VTI was the retail winner in the inaugural Morningstar Awards for ETFs.

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.

Fundamental View
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.

Fund Construction
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 (SCHB) in costs in the past and we expect with the recent index change it will continue to do so. In addition, VTI the greater trading volume and tighter tracking in VTI lead to lower trading costs when compared with SCHB.

Alternatives
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 (IWV), which holds the 3000 largest stocks, nearly as many as VTI. IWV charges 0.20%.

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Disclosure: Morningstar, Inc. licenses its indexes to institutions for the creation of ETFs and ETNs. Morningstar receives fees that are mainly based on fund assets under management. AlphaPro Management, BlackRock Asset Management, First Asset, First Trust, Invesco, Merrill Lynch, Northern Trust, Scottrade, and Van Eck currently license Morningstar Indexes. These ETFs and ETNs are not sponsored, issued, marketed, or sold by Morningstar. Morningstar does not make any representation regarding the advisability of investing in ETFs or ETNs that are based on the Morningstar Indexes.