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Index Investment Shifting to Total-Market Funds From S&P 500

Ian McDonald

Looks like indexers have found a new heartthrob.

Vanguard's $104.8 billion (VFINX Quote)500 Index fund, which tracks the S&P 500, might be the biggest mutual fund in the nation, but so far this year, the firm's $19.3 billion (VTSMX Quote)Total Stock Market Index is its top seller and has doubled the 500 Index fund's sales.

Investors have pumped $2.3 billion into the Total Stock Market fund this year through April 30, compared with a little more than $1 billion they put into the 500 Index, according to Boston-based fund consultant Financial Research.

The shift probably appears to have been spurred by Vanguard's stepped-up promotion of the Total Market fund, which tracks the Wilshire 5000 index as a core stock holding. At investor conferences and in the media, former Chairman John Bogle and current Vanguard officials like index guru Gus Sauter have highlighted the broader-market fund.

"More dollars are going into the Total Market fund, because Bogle's been blowing that horn," says Jeff Troutner, president of TAM Asset Management in San Anselmo, Calif. and senior editor of Indexfunds.com.

Why? The firm's motives may be entirely altruistic. Vanguard officials may simply want investors to seek more diversification. But they also may be queasy about having so much money pegged to the S&P 500 index, which has come to be dominated by pricey large-cap stocks.

When it comes to indexing, Vanguard's opinion carries a lot of weight. Its S&P 500 fund represents one third of all mutual fund assets invested in the category, according to Lipper, and its Total Market index has a dominant position, holding more than 75% of the assets invested in Wilshire 5000-tracking funds.

"Between the 500 and the Total Stock Market for several years we've been saying that Total Stock Market is the better of the two because it has more diversification and less risk," says Vanguard spokesman John Demming.

The S&P 500 is a basket of large-cap stocks from a range of industries picked by Standard & Poor's. The Wilshire 5000 is an index of all publicly-traded U.S. stocks.

"The difference is that the 500 is roughly the largest 500 stocks and the Wilshire is those 500, plus everything else," says Jim Troyer, a member of Vanguard's index-fund team.

Despite its name, the Wilshire 5000 index now has some 6,890 stocks. Buying all those stocks, particularly the smallest ones, would make transaction costs balloon, so most total market funds don't buy all of them. That's not a big deal, because the both of the indices are market-cap weighted, which means larger stocks get the biggest weighting. The smallest 2,100 stocks in the Wilshire comprise less than 1% of its assets, says Troyer.

Here's how the two funds stack up. Keep in mind that, while Vanguard's funds are the largest and cheapest in these categories, there are plenty of other fund shops, including Wilshire, that also offer funds that track these indices.

Index vs. Index Vanguard's S&P 500 and total-market index funds have provided similar returns though there are significant differences in the makeup of their portfolios.
	(VFINX Quote)Vanguard 500 Index	(VTSMX Quote)Vanguard Total Stock Market Index
YTD Return	-2.7%	-4.7%
1-Year Return	10.6%	10.9%
5-Year Annualized Return	24.2%	22.4%
Price-to-Earnings Ratio	36.9	36.6
Median Market Cap	$92 billion	$47 billion
Number of Stocks	500	3,362
% Large-Cap	88.5	71.7
% Mid-Cap	11	18.3
% Small-Cap	0.5	10
% Technology	31.5	35.2
Source: Morningstar. Performance figures through May 30. Portfolio figures through April 30 and may have changed.

The argument for Total Stock Market is that it gives greater access to small- and mid-cap stocks than the S&P 500.

But others say that, since the Wilshire index is market-cap weighted, it isn't much different from the S&P 500. The slim 0.2% difference in the two Vanguard funds' annualized performance over the past five years highlights the two indices' similarities.

While the Wilshire index does hold more small- and mid-cap stocks than the S&P 500, the market-cap weighting makes them a relatively insignificant part of the fund.

The Wilshire index "is only very slightly more diversified than the S&P 500," says Bill Bernstein, a financial adviser based in Coos Bay, Ore.

The folks at Wilshire acknowledge the index's bias toward large-cap stocks, but note that it reflects the same bias in the market.

"Big stocks do have a bigger impact, but that's just the nature of the market," says David Borger, director of research at Wilshire's asset management unit.

Planners and industry watchers say that, while these funds are both tax efficient and cheap, with expense ratios at or under 0.2% annually, they should be considered large-cap growth funds. Planners have some thoughts on how you can get more small- and mid-cap exposure if you want it.

One idea is to divide your core U.S. stock holdings into four slices, committing each to an index fund focusing on large- or small-caps in a value or growth style, suggests Troutner. Such a portfolio would hold large-cap growth and value indices and small-cap growth and value indices. Investors could set a target allocation and keep the portfolio in balance by investing fresh cash in the lagging indices. Troutner worries that some investors might not realize that the recent bull run has made growth stocks a bigger part of both the S&P 500 and Wilshire indices.

If value stocks, which have lagged growth stocks for several years, come back, "a year or two from now people might be wondering what in the world they did," he says.

Others have differing views on how you might add small- and mid-cap exposure to an S&P 500 or Total Market fund. Essentially the choices are actively managed funds, index funds or a blend of both.

Morningstar analyst Peter Di Teresa says investors should stick with the Total Market fund if they're not concerned with getting more small- and mid-cap exposure. If you want more exposure to the guppies, he has a plan.

"I'd suggest buying an S&P 500 fund and then picking actively-managed small- and mid-cap funds," he says. That strategy seems to be endorsed by Morningstar's 401(k) plan. It offers employees an S&P 500 index fund, but they have to add actively managed funds for small- and mid-cap exposure.