S&P 500 vs. Total Stock Market: Which Is Right for You?

Note: This article is part of Morningstar's November 2013 Investor Starter Kit special report. This article originally appeared Sept. 4, 2012.

Question: I'm trying to decide which would make a better core equity holding: an S&P 500 index fund or a total stock market index fund. What should I take into consideration?

Answer: Given the increasing popularity of index funds--which account for about one out of every six dollars invested in equity mutual funds and the vast majority of assets invested in exchange-traded funds--many investors likely have the same question.

For those who might be unfamiliar with the two index types mentioned, the S&P 500 tracks 500 of the largest U.S. stocks as measured by the value of their shares. Because the index is weighted by market capitalization--the number of shares on the market times share price--higher-value companies take up bigger weightings and lower-value companies take up smaller positions. One-third of all index mutual fund assets (not including ETFs) currently are invested in funds that track this index.

Total stock market funds, on the other hand, include both large-cap stocks and the many small- and mid-cap stocks left out of the S&P 500. Total market funds typically track an index such as the MSCI US Broad Market Index or Dow Jones U.S. Total Stock Market Index, which also are cap-weighted and which attempt to measure the performance of all publicly traded U.S. stocks (there also are world- and international-stock indexes that track global and non-U.S. stock market performance, respectively). To help answer your question about which is the better choice for you, let's look at key differences between these two widely used index fund types.

Composition Differences
As we've said, a total stock market index fund encompasses a wider universe of stocks than does the S&P 500, but the difference might not be as great as you think. Stocks in the S&P 500 make up about 80% of the total U.S. equity market capitalization, so the overlap is considerable. That said, the roughly 20% of the market capitalization that is found only in the total stock market index fund does provide greater diversification because of the presence of smaller stocks. For investors with small-cap exposure elsewhere in their portfolios, the large- and mid-cap S&P 500 fund may suffice. But for a broader, one-stop-shopping fund, the total market index offers maximum diversification within the U.S. equity universe.

To illustrate the difference in the composition of these indexes, let's examine the portfolios of two funds that track them. The portfolio of  Vanguard 500 Index (VFINX), which follows the S&P 500, has an average market cap of $61.6 billion. By contrast, Vanguard Total Stock Market Index (VTSMX), which follows the CRSP US Total Market Index, has a smaller average market cap of $34.7 billion.

Also worth noting, though it plays a much smaller role in distinguishing the index fund types from one another, is the fact that the S&P 500 is not a purely cap-determined index. A committee of economists and analysts at Standard & Poor's maintains the index and may exclude companies for a variety of reasons, including that a company is no longer considered financially viable as a result of ongoing losses, that the company's stock is not liquid enough, or because the stock throws off the index's sector balance. In September, Standard & Poor's announced it was dropping  Advanced Micro Devices (AMD) out of the index because its market valuation is too small (AMD was added to the S&P MidCap 400 Index). The CRSP US Total Market Index, however, tracks nearly all publicly available equities that meet minimum liquidity requirements, which equates to roughly 3,600 securities.

Yet another factor at play here is the fact that S&P 500 stocks tend to be widely available, making it relatively easy for funds to track the index. Total stock market indexes, on the other hand, include some of the smallest publicly traded issues, which are cost-prohibitive for fund companies to buy and sell. To help minimize this added trading cost, total market funds might employ a representative sampling method to approximate an index's performance so that they don't have to trade each and every stock in it.

Performance Varies Slightly
So how do S&P 500 and total U.S. stock market index funds compare in terms of performance? The short answer--and that is the name of this column, after all--is not all that differently. Below is a table that shows annualized performance for each fund type during various time periods. Again we'll use Vanguard mutual funds because of their rock-bottom fees, which help reduce any trading-cost noise in performance, and their lengthy track records.

As you can see, the total stock market fund has performed slightly better, but volatility should also be taken into consideration, given that small-cap stocks tend to provide a bumpier ride than large caps. The large-cap-heavy Vanguard 500 fund has a 10-year standard deviation--a measure of volatility--of 14.7, whereas Vanguard Total Stock Market has a 10-year standard deviation of 15.2. So by including smaller stocks, the total market fund also increases its overall volatility, albeit just slightly.

Availability Might Be an Issue
Finally, one other important consideration is the availability of the index funds in question. Many of the larger fund companies offer an index fund and/or ETF tracking the S&P 500. But total stock market funds are less prevalent. For example, larger fund companies such as Fidelity,  T. Rowe Price Group (TROW), and Vanguard offer both types of funds, whereas smaller fund companies might offer only an S&P 500 index fund or neither.

Investors also might be limited by what is available through their employer-based retirement plans. Workers in plans that offer only an S&P 500 index fund, for example, might want to add a small-cap fund to their portfolios for better diversification.

The Bottom Line
S&P 500 and total stock market index funds and ETFs are great ways for investors interested in using a passive investment strategy to own a broadly diversified basket of U.S. stocks. As a bonus, these index funds often charge some of the lowest fees in the investing marketplace. As for which type of index fund best suits your needs, it ultimately comes down to whether you're willing to accept a small step up in volatility with a total market index fund for a potential small step up in performance. That's an individual choice, of course, but a question well worth asking.