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Why Vanguard Total Stock Market isn’t the best fund in the fleet

Reprinted courtesy of MarketWatch.com.

To read the original article click here

For investors who want everything wrapped into a single package, Vanguard’s Total Stock Market Index fund seems a reasonable way to access U.S. large-cap blend stocks.

And there’s plenty to like about Vanguard Total Stock Market Index VTSMX, -1.70% : Low expenses, massive diversification, low turnover and of course — no sales load.

But this fund falls far short of its “total market” title. In fact, the fund gives investors only a small part of what it takes to diversify a portfolio into the best asset classes. This is no small matter, since that diversification accounts for more than 90% of an investor’s likely return.

My goal is to help investors take steps that are likely to increase their returns without taking undue risk. This is crucial: There is absolutely no evidence that owning the Total Stock Market Index Fund (TSMI) will accomplish that goal.

In fact, I think the opposite is true: Relying on this fund is likely to prevent investors from retiring when they otherwise could do so.

Vanguard has earned a lot of credibility among investors through its low costs and broad array of index funds. But for a reason or reasons I don’t understand, the company seems to have a blind spot when it comes to diversification.

Vanguard has basically taken the position that the benefits available from broad diversification aren’t worth the trouble. The past 80 years of stock market historymakes a compelling case that full diversification can add one or two percentage points to the annual return of a portfolio.

Even if the difference is only 0.5%, that can make a huge difference over a typical investor’s lifetime. Diversification, when done properly, can literally double the money an investor can spend in retirement and double the amount that investor can leave to his or her heirs.

Doing this might take an extra hour every year. That’s not worth it? On the contrary, those could be the most profitable hours that most investors ever spend.

So back to the Total Stock Market Index. Over the past eight decades, the return of this index is virtually the same as the return of the Standard & Poor’s 500 IndexSPX, -1.64% Since the Vanguard Total Market fund incepted in 1992, we rely on the representative returns of a total stock market index CRSPTM1, -1.70%  provided by Dimensional Fund Advisors, which they’ve tracked back to 1926.

DECADE RETURNS 1930 THROUGH 2009

The following are the decade annualized returns for the S&P 500, U.S. Total Market, U.S. Large Cap Value, U.S. Small Cap and U.S. Small Cap Value. Returns are in %s.

Asset Class:  30-39 40-49 50-59 60-69 70-79 80-89 90-99 00-09 1930-2013
S&P 500 Index -0.1 9.2 19.4 7.8 5.9 17.5 18.2 -0.9 9.7
Total Stock Market -0.2 9.6 18.2 8.3 6.1 16.7 18.0 -0.3 9.7
Large-Cap Value -5.7 12.7 18.4 9.4 12.9 20.6 16.8 4.1 11.2
Small-Cap 2.3 14.9 19.2 13.0 9.2 16.8 15.5 9.0 12.7
Small-Cap Value -2.6 19.8 19.6 14.4 14.4 20.1 16.2 12.8 14.4

Includes reinvestment of dividends. Source: Dimensional Fund Advisors

Yet many TSMI investors I’ve spoken with believe they are getting something better and more profitable than they would have with the S&P 500. Some of them cite the TSMI’s 9% stake in small-cap stocks as proof that that index represents all asset classes. Nice try, but, where’s the beef? The long-term return is still 9.7%.

One reason is that nearly half of the small-cap stocks in the index are growth stocks, representing an asset class that historically has often underperformed the S&P 500, not outperformed it.

To add a meaningful boost to the S&P 500, an index needs value stocks. The best data at my disposal indicates that over the long haul, small-cap value stocks returned 14.4%, far better than the S&P 500’s 9.7% return. That is like a booster rocket, yet only about 3% of the TSMI is made up of small-cap value stocks.

As you probably know, Warren Buffett has relied on a value-stock investing style to become one of the wealthiest men in history. Most experts agree that value companies are likely to continue to produce higher long-term returns than growth companies. And yet only about one-third of the TSMI is made up of value companies.

Vanguard, of course, isn’t responsible for the makeup of the TSMI. But Vanguard is on the hook for the advice it gives investors. And I don’t think that advice is adequate.

Many times I’ve talked to investors who wanted to use Vanguard funds to follow my advice about the best way to diversify a portfolio. Time and again I have heard that Vanguard phone advisers tried to convince investors that they should not put more small-cap and value stocks into a portfolios. In my view this is lousy advice that is not supported by the evidence from the past 80 years.

For hundreds of thousands of investors — maybe even millions — Vanguard compounds the damage from this point of view by using the TSMI and its international counterpart for much of the portfolios in its target-date funds.

There’s a world of difference between the TSMI and the funds (less than a dozen) that I recommend. I suspect millions of investors don’t even know they have such relatively easy choices that can make a huge positive difference in their financial lives. That’s a shame, and I am puzzled, and really disappointed, by the fact that Vanguard isn’t doing more to help out.

For more reasons to avoid the TSMI, I invite you to check out my recent podcast on this topic.

Richard Buck contributed to this article.