A Low-Cost, Core Equity Portfolio From iShares

A broad index fund is a better option for investors building a complete allocation to U.S. equities than using separate size segment funds. Because a broad fund holds both large- and small-cap stocks, it is not forced to buy or sell as stocks migrate into a different market-cap range. This low turnover can promote tax efficiency. However, separate size segment funds may be viable for investors who prefer to more tightly control their allocation or to give an overweighting to certain segments of the market.

Although it reaches further down the market-cap ladder, the S&P 1500 had more than a 0.99 correlation to the S&P 500 during the past decade. Despite this high correlation, the S&P 1500 returned an annualized 7.89% during that time period, while the S&P 500 returned 7.67%. Strong returns of smaller stocks helped drive this superior performance. It accomplished this higher return with only slightly greater volatility (standard deviation of 15.0%) than the S&P 500 (14.7%).

As a market-cap-weighted index fund, the investments in this fund represent the dollar-weighted average of investors' U.S. stock holdings. Therefore, its performance should be similar to the average U.S. investor's, before fees. However, its 0.07% expense ratio gives it nearly a 1-percentage-point cost advantage relative to the average large-blend fund. As a result, during the past 10 years, the fund's return outpaced more than 75% of all large-blend mutual funds that survived the period.

Fundamentals U.S. stocks have had an annualized return of 10.1% nominal and 7.0% real in the 89 years since 1925. This handily beat the 2.3% real return on intermediate-term U.S. government bonds. Of course, stocks were much riskier. The 7.0% long-term average masks dramatic variation in stock returns over shorter spans. The calendar-year real return on stocks has been as low as negative 37% and less than negative 10% in 17 out of 89 years. Real returns can also be negative for extended periods of time, as they were for the 12-year period between 1972 and 1984 and the six-year period between 1999 and 2005. Investors in equities need to be able to withstand periods of losses.

The return for stocks can be broken down into two components: dividends and capital appreciation. The dividend yield on U.S. stocks is currently about 2%. While that is lower than the historical average of 4%, it is high relative to the available yield on government bonds. In addition, dividend payout ratios are lower than what they were in the past, meaning that firms are retaining more capital, which could result in faster earnings growth or share buybacks.

Capital appreciation is driven by a combination of growth in earnings and changes in the valuation multiple that investors apply to those earnings. Real earnings growth has historically averaged around 2% since 1926 but has accelerated during the past 10 years because of above-average profit margins and higher earnings reinvestment rates. Valuation multiples tend to mean revert over time. Valuations cannot grow faster than earnings indefinitely because a stock's intrinsic value is essentially the present value of its future cash flows (which are closely tied to earnings). When valuation multiples are higher than average, future returns tend to be lower, and vice versa, although the relationship is volatile, particularly over short horizons. Changes in valuation multiples can drive short-term returns, but they are hard to predict and have historically been the smallest component of long-term returns.

Investors can look at several measures to gauge market valuations. The cyclically adjusted price earnings, or CAPE, ratio attempts to smooth outliers by using 10 years of trailing inflation-adjusted earnings data. The CAPE is currently above its post-World War II average of 16 times. Valuations are driven by expectations about future growth, interest rates, inflation rates, and investor risk aversion. Among these factors, the real interest rate and the inflation rate are below their long-term averages. Because there is an inverse relationship between interest rates and valuations, low current interest rates help support higher valuations. While CAPE looks at trailing earnings, two other measures incorporate expectations about future earnings. The price/forward earnings ratio is currently about 19 times, compared with an average of 16 times since 2000. It may also be useful to consider the fund's price/fair value multiple. This is based on Morningstar analysts' fair value estimates of the fund's underlying holdings based on discounted cash flow analysis. A price/fair value significantly above 1 indicates lower expected returns in the future. Currently, stocks in this fund trade at a price/fair value ratio of 0.98.

Portfolio Construction This exchange-traded fund tracks the S&P 1500 Index, which includes approximately 90% of the investable U.S. equity market. The index is a composite of the venerable S&P 500, MidCap 400, and SmallCap 600 indexes. Because it weights its holdings by market capitalization, nearly 78% of its assets are tucked into giant- and large-cap stocks. Although highly correlated to other total-market benchmarks like the Russell 3000, the S&P 1500 uses slightly more stringent index inclusion rules regarding IPO seasoning, domicile, float requirements, and profitability. These screens result in some gaps in coverage compared with more-mechanical indexes and may slightly skew the index toward more profitable companies. The portfolio is well diversified by sector and across individual names and it should continue to exhibit a high correlation with other core stock indexes. The fund follows a full replication strategy, holding virtually all 1,500 stocks in the index. Full replication helps minimize tracking error.

Fees This fund charges a razor-thin 0.07% expense ratio, which is lower than most indexed mutual funds available to individual investors. However, this fund is not as liquid as several alternative broad-market ETFs, which can make it more expensive to trade in large blocks. Buy-and-hold investors should focus more on the expense ratio because they incur trading costs less frequently. The fund has done a good job of matching its index since it cut its expense ratio in 2012.

Alternatives

Those who prefer to more precisely control their allocation to large-, mid-, and small-cap stocks can invest in the subcomponents of the S&P 1500 separately through

Disclosure: Morningstar, Inc.'s Investment Management division 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.