By
Morningstar
:
By Michael Rawson, CFA
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 cannot 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 U.S. 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 security 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, 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 3,000 largest stocks, nearly as many as VTI. IWV
charges 0.20%.
Disclosure:
Morningstar licenses its indexes to certain ETF and ETN providers,
including BlackRock, Invesco, Merrill Lynch, Northern Trust, and
Scottrade for use in exchange-traded funds and notes. These ETFs
and ETNs are not sponsored, issued, or sold by Morningstar.
Morningstar does not make any representation regarding the
advisability of investing in ETFs or ETNs that are based on
Morningstar indexes.
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