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ETF Specialist

Spring Cleaning: Use This ETF to Simplify Your U.S. Equity Allocation

A one-stop holding for broadly diversified exposure to the U.S. stock market at a low price.

Our team recently investigated how stylistic differences between active and passive managers contribute to the variation of active managers' performance within Morningstar Categories. While these differences can help explain when actively managed funds outperform their passively managed peers, investment style differences don't account for everything, nor do they always line up how we'd expect. It's not advisable to attempt to time exposure between index and active managers because this is akin to timing just about anything else in the market--it's hard to do successfully.

Investors can avoid U.S. equity fund style decisions by selecting a total market fund like  iShares Core S&P Total U.S. Stock Market ETF (ITOT). This is an attractive choice for diversified exposure to U.S. stocks of all sizes and spans the value/growth continuum. The exchange-traded fund efficiently tracks a broadly diversified and representative benchmark at a low cost, which gives it a persistent edge over its peers. It earns a Morningstar Analyst Rating of Gold.

This fund tracks the S&P U.S. Total Market Index, a market-cap-weighted index that represents nearly every investable U.S. stock. Market-cap weighting pulls the portfolio toward the largest U.S. stocks and accurately reflects the composition of the market. The fund's average market cap of just under $60 billion is slightly higher than the average fund in the category. The fund is well diversified: It owns nearly 3,500 stocks, and its top 10 holdings represent less than 17% of its portfolio.

Low turnover is a key advantage of the fund's market-cap-weighted approach because changes in the prices of its holdings mirror changes to their weightings in the market. Compared with large-cap index-tracking funds, this fund benefits more from weighting by market cap because it owns stocks of all sizes and doesn't have to sell or buy names as they cross arbitrary market-cap size segments. Lower turnover means lower transaction costs and a smaller likelihood of taxable capital gains distributions. The fund's average turnover during the past decade was 6% compared with an average figure of more than 60% for its category peers. Tax efficiency adds to the fund's appeal. It has not distributed any capital gains since its inception in 2004.

During the past decade through March 2018, this fund outpaced the large-blend category by 2.4% annually with similar risk. This index fund can carry meaningful risk because it remains fully invested. The fund's drawdown of 55% during the bear market from October 2007 through March 2009 was larger than the average fund in the category. But its smaller cash drag should pay off during market rallies. The fund's performance during the subsequent market recovery more than made up for its deeper drawdown. Much of the fund's relative outperformance can be attributed to its sustainable cost advantage.

Fundamental View
Broadly diversified, market-cap-weighted index funds like this one derive a persistent edge from efficient portfolio construction. The fund's broad, market-cap-weighted portfolio accurately represents its peers' opportunity set. Stock prices, which drive the fund's weightings, quickly incorporate new information and reflect the collective wisdom of the market (or madness of the crowd).

However, the fund's market-cap-weighted portfolio can lead to large positions in a few sectors and mega-cap stocks. While the portfolio is currently well-diversified, it has experienced high sector concentration in the past. For example, the technology sector represented about a third of the S&P 500 during the tech bubble in the late 1990s. But this risk is a small price to pay for the efficiency and cost advantage gained from market-cap weighting.

Although the fund relies on others in the market to set the prices and weightings of its holdings, it benefits from low turnover and transaction costs. During the past decade through 2017, this fund's turnover measured just under 6% versus more than 60% for the average fund in the large-blend category. Market-cap-weighted index funds are also cheaper to run than most actively managed funds because they require fewer investment personnel. If the fund sponsor passes on the economies of scale to fundholders through lower management fees, as this fund does, then investors benefit from a low fee hurdle to clear each year.

Market-cap-weighted index funds carry lower cash balances than their actively managed counterparts, which helps performance during bull markets but detracts during bear markets. For example, ITOT lost 55 percentage points during the bear market from October 2007 through March 2009, slightly more than the average large-blend fund during this time period. But because index funds stay nearly fully invested, they won't miss the upside. The fund's cash balance averaged only 0.1% for the decade through March 2018. This figure is a tiny fraction of the category's average cash balance of 3.3% over this period. From the trough of the bear market in March 2009 through March 2018, this fund handily outpaced the average fund in the category.

ITOT owns stocks of all sizes, but its market-cap-weighting approach pulls its portfolio toward the largest U.S. stocks. The fund's average market cap of $60 billion is slightly greater than that of the category average. The fund's sector weightings do not differ much from the category average, but it has a slightly higher weighting in technology stocks. While it skews toward the largest U.S. stocks, the fund does invest in small stocks without sustainable competitive advantages. As of this writing, 46% of this portfolio is invested in companies with Morningstar Economic Moat Ratings of wide compared with 57% for the average fund in the category. This goes hand in hand with the fund diving lower down the market-cap spectrum than the average fund in the category and may slightly increase its risk. But that risk may compensate investors with higher returns and is largely mitigated by the fund's broad diversification.

Portfolio Construction
This fund represents the entire investable U.S. equity market, effectively harnessing the market's collective wisdom and diversifying risk. It earns a Positive Process Pillar rating.

The fund tracks the S&P Total Market Index, which holds nearly every investable U.S. stock. It switched from tracking the S&P 1500 Index to the S&P Total Market Index in mid-December 2015. The S&P Total Market Index includes essentially all stocks traded on a major exchange that have readily available prices. In contrast, the S&P 1500 includes approximately 90% of the investable U.S. equity market. The primary difference between the two indexes is that the S&P Total Market Index includes micro-cap stocks and does not screen index additions for financial viability. Because both indexes weight constituents by market cap, their returns are highly correlated. While REITs are eligible for inclusion in the index, business-development companies, master limited partnerships, and over-the-counter bulletin-board issues are not eligible. The managers have historically used securities lending to generate additional income to offset the fund's expenses and equity futures to invest excess cash.

ITOT carries a low fee of 0.03%, making it one of the cheapest stock funds available. This is a fraction of the 0.84% median levy that its large-cap blend category peers charge, supporting the fund's Positive Price Pillar rating.

During the past year through March 2018, the fund outpaced its benchmark by 4 basis points. This implies the fund has been able to overcome its expense ratio through a combination of savvy portfolio management techniques and securities-lending revenue.

Investors looking for one fund to cover most of the U.S. equity market have a few good alternatives.  Vanguard Total Stock Market ETF (VTI) (0.04% expense ratio) owns nearly every publicly traded U.S. stock and offers good liquidity. ITOT and VTI have a comparable number of holdings and near-identical exposure from top to bottom down the market-cap spectrum.  Schwab U.S. Broad Market ETF (SCHB) (0.03% expense ratio) holds about 2,000 of the 2,500 stocks in the Dow Jones U.S. Broad Stock Market Index, giving it a somewhat narrower portfolio relative to ITOT and VTI. Like ITOT, VTI and SCHB are rated Gold.

There are also plenty of dedicated U.S. large-cap ETF options.  Vanguard S&P 500 (VOO) and  iShares Core S&P 500 (IVV) both track the well-known S&P 500. These funds each levy a 0.04% annual fee and carry a Gold rating.  Vanguard Large-Cap ETF (VV) (0.06% expense ratio) represents the large-cap portion of the CRSP U.S. Total Market Index, which covers the largest 85% of U.S. stocks by market cap and employs generous buffering rules to reduce turnover.  Schwab U.S. Large-Cap (SCHX) (0.03% expense ratio) is another dedicated large-cap ETF. SCHX tracks the Dow Jones U.S. Large-Cap Total Stock Market Index, which targets the largest 750 U.S. stocks. Both of these funds reach a bit further down the market-cap spectrum, so they are more broadly diversified than the S&P 500. VV and SCHX earn Gold ratings.


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Adam McCullough has a position in the following securities mentioned above: VTI. Find out about Morningstar’s editorial policies.