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  • Home>Research & Insights>Investment Insights>The World's Largest Fund Just Got a Bit Cheaper

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    The World's Largest Fund Just Got a Bit Cheaper

    It is hard not to like this fund, especially following another fee cut.

    Ben Johnson, 05/19/2017

    Vanguard Total Stock Market ETF VTI offers investors diversified exposure to the U.S. stock market. A low fee and a soundly constructed and reasonably representative benchmark leave this exchange-traded fund well-positioned to continue its long streak of producing superior risk-adjusted returns relative to its large-blend Morningstar Category peers over the long haul and underpin its Morningstar Analyst Rating of Gold.

    During the 20-year period ended April 30, 2017, the Admiral share class of the Vanguard Total Stock Market Index fund (used as a proxy here given that VTI's inception was in May 2001) returned 8.01% per year, outstripping the U.S. large-blend average by 1.61 percentage points per year. Much of this relative outperformance can be attributed to the fund’s sizable fee advantage. At 0.04%, VTI’s annual levy is a tiny fraction of the 0.90% median fee charged by its peers in the large-blend category.

    Broad diversification is an intrinsic advantage of funds tracking market-capitalization-weighted total stock market indexes, which capture nearly the entirety of the investable market capitalization of the U.S. equity market. However, market-cap weighting has its pluses and minuses. It can be a beneficial approach in momentum-driven bull markets that are characterized by large-cap leadership, such as the post-financial-crisis charge in U.S. stocks. But it can also lead to significant sector and single-security concentration, as witnessed at the height of the technology bubble. So market-cap-weighted indexes’ greatest strength is arguably also their Achilles’ heel.

    Low turnover is another key advantage of a fund tied to a cap-weighted benchmark. Lower turnover equates to lower costs and a lesser likelihood of taxable capital gains distributions. VTI’s median annual turnover was 10% during the trailing 10-year period. This compares with a median figure of 66% for its category peers.

    While VTI possesses a sizable fee advantage, there is a pair of less-expensive options available for long-term investors. Many might be marginally better off investing in the lowest-cost options of all, iShares Core S&P Total US Stock Market ITOT or Schwab US Broad Market ETF SCHB, both of which charge an annual fee of 0.03%.

    Fundamental View
    In their history, broadly diversified market-cap-weighted indexes have proved a difficult hurdle for many U.S. large-cap managers to clear. The first S&P 500 fund, Vanguard 500 Index VFINX, was launched 40 years ago. Few actively managed U.S. large-cap stock funds that were around in 1976 are still in existence today. Fewer still managed to produce better returns than Vanguard 500 Index during the past four decades.

    Many attribute active managers' collective struggles to best index funds to the overall level of efficiency of the market for U.S. large-cap stocks. Efficiency in this case is meant to indicate the speed and precision with which market participants incorporate new information into stock prices. Furthermore, given advances in information technology and the growth in the portion of investable assets that is managed by an increasingly skilled set of professional investment managers, it can be argued that the market has become ever more efficient over time. But market efficiency alone does not explain the long-term success of broadly diversified market-cap-weighted index funds.

    The second leg of the investment thesis for index funds is their cost advantage. Index funds are less expensive to manage than actively managed alternatives. Their sponsors don't have to pay teams of portfolio managers and investment analysts to identify under- or overvalued stocks to be added to or sold from their portfolios. Also, market-cap-weighted index funds have lower turnover relative to actively managed funds. Turnover has a price. Commissions, bid-ask spreads, and market-impact costs all add to the headwinds facing active strategies. Also, turnover has tax implications. Higher-turnover actively managed funds will regularly distribute taxable capital gains to their shareholders. This creates an additional drag on these funds’ performance in the case where they are held in taxable accounts. Taken together, these costs are the largest and most persistent drag on the performance of actively managed strategies.

    Ben Johnson is Morningstar’s Director of European ETF Research.