Try the new version of Icarra! new

Ticker:
New to Icarra? Take the tour.Have a question? Send an e-mail to Icarra Support.

S&P 500 vs. Total Stock Market

by Jesse Liesch

This is the second part of a two part article. Click here to go back to page 1.

Performance

The question everyone wants to know is: Will owning the Total Stock Market make me more money? The answer is a resounding maybe, and a very possible yes.

Many smart people think small and medium cap stocks will slightly outperform large cap stocks over time. Many other smart people disagree with them. I tend to believe the first group of people. If we are correct then the Total Stock Market will outperform the S&P 500 due to its exposure to small and mid cap stocks.

One problem with the S&P 500 is that it is an actively managed index. Companies are continually added to and removed from the S&P 500. Each time the index is changed an S&P 500 mutual fund will have to sell shares of the stock leaving the index and buy shares of the stock entering the index. This will create a drag on performance due to:

  1. Commissions: Stocks are not bought and sold for free.
  2. Capital Gains: If the sold stock has appreciated then you will pay taxes on the capital gains. This is not an issue in a retirement account.
  3. Bid-Ask Spreads: The final purchase price for a stock will be higher than its quoted price.
  4. Market Impact Costs: Companies added to the S&P 500 may see their stock price increase, while companies that leave the S&P 500 may see their stock price decrease. Your S&P 500 mutual fund may sell its stock after the price has decreased, and buy the stock's replacement after it has increased in price.

In contrast the Total Stock Market will remain unchanged by this event. These factors are most prominent in small cap stocks and are less important with the large cap stocks found in the S&P 500, however they are still present.

A Total Stock Market index fund will have marginally higher expenses than an S&P 500 index fund. The expense ratio for VTSMX (Total Stock Market) is currently 0.19% and the expense ratio of VFINX (S&P 500) is 0.18%. This should not be an issue for the level-headed reader.

For the reasons listed in this section I recommend owning the Total Stock Market. Please keep in mind that any out performance will be small. Both the Total Stock Market and S&P 500 would make a stunning centerpiece for your portfolio.

Slicing and Dicing

There is one situation where I would recommend owning the S&P 500 instead of the Total Stock Market: In a slice and dice portfolio. There may be better index funds for this portion of a slice and dice portfolio, however, such as the Vanguard Large-Cap Index Fund (VLACX). If you don't know what slice and dice means then you're not going to learn in this article, so skip to the next section. Really.

The S&P 500 makes a better component of a slice and dice portfolio than the Total Stock Market because it has a lower correlation with small and medium cap funds. This happens because the small and medium cap portions of the Total Stock Market correlate perfectly with their corresponding index. This increases the correlation of the Total Stock Market with small and medium cap indices. The R value of NAESX (Vanguard small cap index) is 0.72 for the S&P 500 but 0.84 for the Total Stock Market (measured from 6/20/1996 to 1/24/2006). This will theoretically yield a better performance boost from rebalancing, if you believe in that sort of thing.

Conclusion

Here is the entire article re-written in a few less words:
  1. The S&P 500 and Total Stock Market are fabulous indices. Both would make an excellent core holding for your portfolio.
  2. The Total Stock Market is more diversified than the S&P 500.
  3. The Total Stock Market may perform slightly better than the S&P 500 in the long term.
  4. The S&P 500 is a better component of a slice and dice portfolio than the Total Stock Market (although there may be better large can index funds for this purpose).

If you have any questions or comments please email me. If you think you have found an error then keep looking because you are probably wrong. Just kidding. Please, let me know.

Footnotes

  1. How can one trust an index that lies about the number of stocks it owns? If you're like me you were very disappointed to learn that the Wilshire 5000 doesn't contain 5000 stocks. This doesn't make it any less of an index. Lets just blame it on the marketing department.
  2. To see the logical order of the universe break down, one only needs to read the justification for owning an actively managed mutual fund instead of an index fund.
  3. In reality VTSMX and similar funds will not necessarily own the expected amount of some small cap stocks. Owning every stock in the Total Stock Market would be inefficient and lead to higher costs. Instead a Total Stock Market fund will own a sample of all small cap stocks. Although not 100% correct, the differences are too small to notice.