A huge part of almost every equity investor’s portfolio consists of large-cap stocks. But investors also want some exposure to mid-cap and small-cap stocks for better long-term returns. That’s why there is a lot of talk about the Total Stock Market funds that cover almost the entire investable US equity market. Many have pitched the Total Stock Market index as a superior alternative to the S&P 500. In this S&P 500 (INDEXSP:.INX) vs Total Stock Market index comparison, let’s check out how they differ.
Vanguard Group popularized the S&P 500 index funds. But in 2018, it replaced the S&P 500 index fund with a Total Stock Market index fund in the 401(k) retirement plan of its own employees. Vanguard employees can no longer choose S&P 500 index funds in their 401(k) retirement plan. Currently, Vanguard’s Total Stock Market ETF (VTI) has more assets than its S&P 500 ETF (VOO).
S&P 500 index
Almost all major ETF and index fund companies offer products tracking both the S&P 500 and the Total Stock Market index. Both of them are considered “blend” indices, meaning they include growth as well as value stocks.
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The S&P 500 index consists of the 500 largest stocks in the US by market capitalization. Having 500 stocks in an index fund/ETF offers sufficient diversification. But the index is weighted by market capitalization. It means mega-cap stocks like Apple, Microsoft, Amazon, Alphabet, Facebook, and Berkshire Hathaway account for a large percentage of the index.
The top 10 largest stocks have close to 24% weightage in the S&P 500 index. The remaining 490 or so companies make up about 76% of the index. Fluctuations in the prices of mega-cap stocks have a much bigger impact on the index returns than the ups and downs in smaller stocks.
For a long time, investors have believed that the S&P 500 index captures the core of the US equity markets. Vanguard Group founder Jack Bogle had even argued that the index also provides healthy international diversification because most American corporations generate a large percentage of their revenues from overseas markets. Warren Buffett has also said that investing in the S&P 500 index is good enough for most investors.
The Total Stock Market index
Proponents of the Total Stock Market index funds/ETFs claim that it offers greater diversification than the S&P 500 index. These funds track the broader equity market including the large-cap, mid-cap, small-cap, and micro-cap stocks. That’s a high level of diversification. But we need to dig a little deeper to get a better understanding of the Total Stock Market funds.
These funds track the CRSP U.S. Total Market Index, Wilshire 5000 Index or the Russell 3000 Index. Vanguard’s Total Stock Market ETF (VTI), the world’s largest Total Stock Market ETF, tracks the CRSP U.S. Total Market Index.
The CRSP U.S. Total Market Index consists of a little over 3,550 stocks. That’s much higher than the 500 stocks covered by the S&P 500. But just like S&P 500, the CRSP U.S. Total Market Index is weighted by market capitalization. As a result, the top 500 largest stocks that constitute the S&P 500 account for nearly 80% of the CRSP U.S. Total Market Index. That’s why the two indices have a high correlation.
The remaining 3,000 or so stocks account for only about 20% of the index. The inclusion of the small-cap and micro-cap stocks in the index makes it slightly riskier, but could also benefit investors in the long run.
S&P 500 vs Total Stock Market index: Which is better?
The constituents of the S&P 500 make up for close to 80% of the Total Stock Market index. In both indices, the largest stocks are responsible for most of the gains or losses. That’s why the two have generated similar performances over the years.
To get a better perspective, let’s compare the returns of Vanguard’s S&P 500 ETF with the same fund house’s Total Stock Market ETF. They both have the same expense ratio of 0.03%. And they both offer high liquidity and minimal tracking error.
The top 10 largest holdings account for 23.90% of the S&P 500 ETF and 19.90% of the Total Stock Market ETF. The top ten constituents are also the same.
Their returns over the years are also similar (below). The 10-year return data is not available for the Vanguard S&P 500 ETF because the fund was launched in July 2010. It’s not 10 years old yet. For 1-year, 3-year, and 5-year, the returns of the two ETFs are similar.
If you think 5-year or 10-year are not long enough time horizons to compare the two indices, the longer history also tells the same story. According to data from MarketWatch, the S&P 500 returned 7.8% annually between 1928 and 1974, compared to 7.3% for the Total Stock Market index. Between 1928 and 2018, the S&P 500 has compounded at 9.7% compared to the TSMI’s 9.5%. Pretty close.
The Sharpe ratio, which reflects the risk-adjusted returns – is also nearly identical for the two indices. The Total Stock Market index gives you a small exposure to mid-cap, small-cap, and micro-cap stocks. But in terms of risk-adjusted returns over the long-term, it’s not significantly better than the S&P 500 index.
Your other options
If you want a truly diversified portfolio and you have the risk appetite to invest in mid-cap and small-cap stocks, you can better capture the total stock market by investing in a few index funds/ETFs that separately represent different market segments.
For instance, you can invest in the S&P 500 for large-cap exposure, an S&P Midcap 400 fund for mid-cap exposure, and a Russell 2000 fund for small-cap exposure. Depending on your risk appetite, you can have a greater exposure to any of the three segments.
Data from MarketWatch shows that over the long-term, the small-cap value funds have significantly outperformed both the S&P 500 and the Total Stock Market index, but they also carry a greater risk.
It’s important to select the right stock fund based on your risk appetite and needs. But equally important is to stick with your investments over the long-term. Switching funds every now and then could affect your returns.