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ETF Specialist

Use This Cheap Fund to Simplify Your Portfolio

A one-stop holding for exposure to the U.S. stock market.

Index providers take different approaches to partitioning the U.S. equity market by size. These methodological differences seem small, but they lead to the risk that investors may unknowingly create overlapping size-segment exposures--even if they own funds tracking indexes from the same index family. This is because these index families' market-cap segments are not always mutually exclusive. 

Investors can avoid unintentional double-dipping by owning a total market strategy like  Schwab U.S. Broad Market ETF (SCHB). This strategy is an excellent option for diversified exposure to U.S. stocks of all sizes. This fund gains a persistent edge over its peers by efficiently tracking a broadly diversified and representative benchmark at a low cost. It earns a Morningstar Analyst Rating of Gold.

This strategy tracks the market-cap-weighted Dow Jones U.S. Broad Stock Market Index, which holds roughly the largest 2,500 U.S. stocks. Market-cap weighting pulls the portfolio toward the largest U.S. stocks and accurately reflects the composition of the market.

There are a few benefits of weighting by market cap. This approach incorporates the cumulative knowledge aggregated in stock prices to size its positions. It keeps costs low because it doesn’t require fundamental research analysts or skilled stock-pickers, who can be expensive to hire. While the market doesn’t always get things right, it has done a good job valuing stocks over the long haul.

Low turnover is another key advantage of the fund’s broad market-cap-weighted approach, as it mitigates transaction costs and the likelihood of taxable capital gains distributions. Compared with funds that track specific market size segments, this fund benefits more from weighting by market cap because it doesn’t have to sell or buy names as they cross arbitrary size segments. The fund’s average turnover over the past decade measured a small fraction of the average turnover of its large-blend Morningstar Category peers. Tax efficiency adds to the fund’s appeal. It has not distributed any capital gains since its inception in 2009.

From its inception in November 2009 through March 2019, the fund has outpaced the category average return by 2.0% annually with similar risk. Much of its relative outperformance can be attributed to its low-cost advantage. The fund carries meaningful risk. The index it tracks fell by more than the average large-blend peer during the bear market from October 2007 through March 2009. As a passive index strategy, this portfolio is always fully invested, so it won’t miss a rally, but it exposes investors to the full brunt of market downturns.

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. From this fund’s inception in 2009 through 2018, its turnover measured a small fraction of 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, this fund’s index 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 has averaged only 0.1% from its inception in November 2009 through 2019. This figure is a tiny fraction of the category’s average cash balance over this period.

This fund owns stocks of all sizes, but its market-cap-weighting approach pulls its portfolio toward the largest U.S. stocks. The fund’s sector weightings do not differ much from the category average, but the fund has a higher weighting in telecommunication services stocks. Because the fund holds stocks of all sizes, it will hold small stocks without sustainable competitive advantages. As of this writing, 48% of this portfolio is invested in companies with wide Morningstar Economic Moat Ratings 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 investors may be compensated for that risk with higher returns, and it is largely mitigated by the fund’s broad diversification.

Portfolio Construction
The fund effectively diversifies risk, promotes low turnover, and accurately represents its target market segment, harnessing the market’s collective wisdom. It earns a Positive Process Pillar rating.

This fund tracks the Dow Jones U.S. Broad Stock Market Index, which represents more than 95% of the investable market capitalization of the U.S. equity market. Although similar to total-market benchmarks like the Russell 3000 Index, the fund has less exposure to micro-cap stocks because it doesn’t reach as far down the market-cap spectrum. However, the fund's sector and style allocations nearly match those of other total U.S. stock market index funds and ETFs. It should continue to exhibit a high correlation with other core stock indexes. The fund employs a representative sampling methodology, but the strategy holds nearly all of the index’s 2,500 stocks. Representative sampling can lower transaction costs among the smallest and most illiquid stocks in the index.

The fund carries a low fee of 0.03%, making it one of the cheapest funds in the large-blend category and supporting a Positive Price Pillar rating. This is a fraction of the median category fee of 0.65%.

During the trailing year through February 2019, this fund outpaced its benchmark by 1 basis point per year. This implies the fund has been able to more than offset the performance drag created by its fee through a combination of savvy portfolio management techniques and securities lending.

Investors looking for one strategy to cover most of the U.S. equity market have a variety of alternatives available. Both  Vanguard Total Stock Market ETF (VTI) and  iShares Core S&P Total U.S. Stock Market ETF (ITOT) own nearly every publicly traded U.S. stock and levy 0.04% annual expense ratios. These funds reach further down the market-capitalization ladder than SCHB and earn Analyst Ratings of Gold.

There are also plenty of dedicated U.S. large-cap ETF options.  Vanguard S&P 500 ETF (VOO) and  iShares Core S&P 500 ETF (IVV) both track the venerable S&P 500. These Gold-rated funds each levy a 0.04% annual fee.  Vanguard Large-Cap ETF (VV) (0.05% expense ratio) covers the largest 85% of U.S. stocks by market cap and employs generous buffering rules to reduce turnover.  Schwab U.S. Large-Cap ETF (SCHX) (0.03% expense ratio) is another strong dedicated large-cap ETF. SCHX tracks the Dow Jones 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 than the S&P 500 and earn Gold ratings.

For those who want to avoid overlap with existing holdings in large-cap stocks or funds, Gold-rated  Vanguard Extended Market ETF (VXF) might be worth considering. The fund tracks an index that represents investable stocks that aren't included in the S&P 500. It charges a competitive fee of 0.08%.


Disclosure: Morningstar, Inc. licenses indexes to financial institutions as the tracking indexes for investable products, such as exchange-traded funds, sponsored by the financial institution. The license fee for such use is paid by the sponsoring financial institution based mainly on the total assets of the investable product. Please click here for a list of investable products that track or have tracked a Morningstar index. Neither Morningstar, Inc. nor its investment management division markets, sells, or makes any representations regarding the advisability of investing in any investable product that tracks a Morningstar index.

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