There’s No Total in Total Stock Index Funds

By Eric Nelson

Investors who have discovered the futility of active management—trying to pick stocks or time their entry to and from the market—often gravitate to “total stock index” funds.  They are low cost, contain almost every publicly traded stock in the market and are inherently tax-efficient.  These are all good qualities.  Unfortunately, total stock investors also tend to believe that they are achieving broad diversification as well, but the evidence finds this simply is not true.

The popularity of total stock indexes began to accelerate in the late 1990s.  As the market for large cap US stocks continued to soar, investors in index funds started to realize that diversifying away from the large cap oriented S&P 500 Index funds may be beneficial.  A handful of very fortunate investors embraced true diversification by adding small or micro cap stocks, as well as large and small value companies to their S&P 500 Indexes.  Others made the mistake of assuming that by swapping an S&P 500 Index fund for a total stock index fund, they would achieve similar levels of diversification without having to use multiple funds.  How could this not be true?  Total stock indexes contain more than 3,000 stocks, compared to only 500 for the S&P 500 index.  How much more diversified can you get?

Unfortunately, the mistake that total stock investors made and continue to make is to ignore that their index fund is capitalization weighted, meaning the biggest stocks have the largest representation in the index—just as the S&P 500 does.  So by swapping the S&P 500 Index for a total stock index, you do pick up a bit more mid and small cap exposure, but at less than 20% of the portfolio it’s not enough to matter much.  Mostly you are just trading your ExxonMobil, Apple, General Electric, Chevron, IBM and Johnson & Johnson shares for one another (these are the top six holdings in both total stock indexes and the S&P 500, and make up 10% to 12% of their total portfolios!), clearly not achieving any additional diversification.

To see real-world proof of the fallacy that total stock indexes provide any additional diversification beyond the large cap market, let’s examine the returns for various stock indexes going back to 1994 (first full year of data for all funds) in Table 1.  Unlike the S&P 500 and total stock indexes, large value, small cap, micro cap and small value indexes put a “cap” on either the price of a company (value) or the size of a company (small/micro cap), ensuring that each portfolio holds separate and distinct companies.

Table 1: Index Results (1/1/1994 through 5/15/2013)

Index Fund

Annualized Return

Growth of $100,000

Vanguard S&P 500 (VFINX)

+8.7%

$508,273

Vanguard Total Stock Index (VTSMX)

+8.8%

$514,732

DFA US Large Value Fund (DFLVX)

+9.9%

$628,943

DFA US Small Cap Fund (DFSTX)

+10.4%

$680,242

DFA US Micro Cap Fund (DFSCX)

+11.1%

$773,880

DFA US Small Value Fund (DFSVX)

+12.1%

$916,101

Source: Morningstar.com

Since 1994, the S&P 500 compounded at a +8.7% return, and turned $100,000 into more than $500,000.  But smaller cap stocks did much better over this period, as did value stocks.  The DFA US Small Cap fund compounded at +10.4% and the even smaller DFA US Micro Cap Fund earned +11.1% per year, producing $170,000 to $260,000 more ending wealth.  The DFA US Large Value fund earned +9.9% per year and the US Small Value fund earned +12.1%, producing $120,000 to $400,000 more wealth.  Certainly, if the total stock index contained any meaningful diversification across smaller and more value oriented stocks, we’d expect to see proof in the returns over this period.  Yet the Vanguard Total Stock Index fund earned a paltry 0.1% more than the S&P 500, and barely produced $6,000 more on a $100,000 investment over almost 20 years!  To see any difference between S&P 500 and total stock indexes, you practically have to look at their returns under a microscope.

The significant costs associated with the faulty view that total stock indexes are anything but a large cap index can be seen in the market returns since 2000.  As the tech bubble burst about 13 years ago, the high-flying results of large cap stocks reversed course, and have failed to produce more than a percent or two compound returns since—precisely the period where you would hope small cap and value diversification would bear fruit.  Table 2 looks at the results for the same index funds beginning in 2000.

Table 2: Index Results (1/1/2000 through 5/15/2013)

Index Fund

Annualized Return

Growth of $100,000

Vanguard S&P 500 (VFINX)

+2.7%

$143,422

Vanguard Total Stock Index (VTSMX)

+3.4%

$157,020

DFA US Large Value Fund (DFLVX)

+7.5%

$263,435

DFA US Small Cap Fund (DFSTX)

+8.7%

$305,711

DFA US Micro Cap Fund (DFSCX)

+9.1%

$321,269

DFA US Small Value Fund (DFSVX)

+11.2%

$417,642

Source: Morningstar.com

Again we see that investors who thought they were getting additional diversification benefits from total stock indexes were sorely mistaken.  Since 2000, the Vanguard S&P 500 Index fund has produced a +2.7% return.  But despite over 6% per year higher returns for small stocks and microcap stocks, and about 5% to 8% higher returns for value stocks, the Vanguard Total Stock index returned only 0.7% more than the S&P 500, a statistical dead heat. 

Unfortunately, with returns of only 2% to 3% for the last 13 years on S&P 500 and total stock indexes, investors who exclusively used these dedicated large cap vehicles to save for retirement are likely finding themselves having to work several more years or save more money.  Retirees who used these indexes as their primary stock vehicle have probably had to begin depleting principal, as reasonable withdrawal rates and inflation have been much higher than their recent returns.

Investors who embraced true asset class diversification, on the other hand, realized significantly greater rewards and peace of mind.  With 7% to 11% returns on the non-S&P 500 elements of their portfolio, it is likely that asset class-based retirement plans or income strategies with modest return expectations continue to coast to a successful financial outcome.

All is not lost for S&P 500 and total stock index funds.  While this article shows why they are virtually identical investments, and total stock indexes provide no additional diversification benefits beyond the large cap-oriented S&P 500, both still represent the large cap market very well.  The vast majority of large cap active managers can do no better than either index, especially after taxes.  And when combined with separate value and small cap asset classes globally, they make for a well-rounded and broadly diversified asset allocation.  Just don’t assume that there is anything “total” about total stock indexes—they are simply large cap indexes by another name.

 

Past performance is not a guarantee of future results.  The returns and other characteristics of the allocation mixes contained in this article are based on model/back-tested simulations to demonstrate broad economic principles.  They were achieved with the benefit of hindsight and do not represent actual investment performance. There are limitations inherent in model performance; it does not reflect trading in actual accounts and may not reflect the impact that economic and market factors may have had on an advisor’s decision-making if the advisor were managing actual client money. Model performance is hypothetical and is for illustrative purposes only.  Model performance shown includes reinvestment of dividends and other earnings but does not reflect the deduction of investment advisory fees or other expenses except where noted. The advisory fees and other expenses they would incur in the management of their accounts may reduce client investment returns. Indexes are not available for direct investment.

 

Eric Nelson is a CFA charterholder who has worked in the investment industry for 15 years.  He is the co-founder of Servo Wealth Management, an independent RIA in Oklahoma City, Oklahoma.  Eric has a passion for educating investors about how capital markets work and helping his clients achieve and maintain financial independence while “simplifying complexity”.  Eric’s research and commentary on investing can be found on his website www.servowealth.com  at the “Servo Thoughts” blog and the “Factors in Focus” newsletter.

 

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