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By Michael Rawson, CFA

Vanguard Total Stock Market (NYSEARCA:VTI) is our favorite equity exchange-traded fund for passive exposure to the U.S. stock market, as it provides the broadest possible exposure for the incredibly low cost of 0.05%, or $5 for every $10,000 invested. While SPDR S&P 500 (NYSEARCA:SPY) may attract more trading volume, it is not the best choice for broad exposure to the U.S. market. Because large-cap stocks dominate the S&P 500 Index, SPY does not include most mid-caps or any small-cap and micro-cap stocks. In contrast, VTI invests in most liquid U.S. stocks, sweeping in more than 3,500 holdings across the market-cap spectrum. Over the long run, small-cap stocks tend to outperform their larger counterparts. This may partially explain why VTI has generated a slightly higher annualized return during the past 10 years (8.04%) than SPY (7.23%).

VTI has about $35 billion in assets, less than a quarter of SPY's $150 billion in assets. But as a separate share class of the Gold-rated Vanguard Total Stock Market Index (VITSX) mutual fund, VTI is part of a $262 billion pool of assets. This large scale spreads fixed costs over more assets and helps to improve efficiency. During the past decade, VTI matched its index almost perfectly, while SPY lagged by 0.11%. SPY is also prohibited from engaging in securities lending, a strategy VTI uses conservatively to offset shareholder expenses.

Holding a total-market index fund is more efficient than holding separate funds for large-cap and small-cap exposure because the broad fund requires less turnover as stocks move up and down in size. VTI is an ideal fund for passive investors who believe in the benefits of index investing, as well as for active investors who wish to follow a core-and-explore approach.

Few equity funds are as diversified as VTI. While this diversification mitigates stock-specific risk, it cannot eliminate the risk of the market itself. For example, the fund had a standard deviation of 15.3% over the past 10 years compared with 14.7% for the S&P 500. The higher risk of VTI is due to the inclusion of more-volatile small-cap stocks. The best way to reduce the risk of VTI further would be to pair it with a high-quality bond fund.

Fundamental View
Since the end of the most recent recession in June 2009, real GDP growth has averaged about 2%. This is below the post-World War II average growth rate of 3%. While a 1% difference in growth may not seem catastrophic, if it continues, it will have a negative impact on earnings growth. It is also disappointing when considering that periods following a recession typically experience above-average growth rates. This slower growth is reflective of a "new normal" economy that can be characterized by lower expected rates of return.

Despite the slower growth, the recovery has been supportive of corporate earnings, which in turn has supported equity markets. The S&P 500 Index rallied by 16% in 2012 and an additional 20% through September 2013. This market appreciation has gotten ahead of the growth in earnings, causing the market to appear expensive. For example, the Shiller P/E, which is the ratio of price/average 10-year earnings, is at 24.0, well above its long-term average of 16.5.

Morningstar equity analysts cover stocks that represent 85% of assets in the U.S. equity market. They build detailed cash flow projections and assign a price/fair value estimate for each stock that they cover. These estimates can then be aggregated to the index level. In mid-September, they see the market trading at a price/fair value of 1.00, which is fairly valued.

The Federal Reserve has pledged to keep the federal-funds rate low until the unemployment rate falls to 6.5%. This has resulted in lower long-term rates for Treasury bonds as well as riskier fixed-income securities, such as corporate and high-yield bonds. However, the Fed has signaled a desire to slow its rate of bond purchases, which helps to lower long-term rates. As a consequence, the yield on the 10-year U.S. Treasury note has increased to about 2.7%. This puts it above the market dividend yield of about 2.0% for the first time in a couple of years. As bonds become more attractive relative to stocks, money likely will flow to bonds and stock returns could be constrained.

Fund Construction
VTI tracks the CRSP U.S. Total Market Index, which holds almost every investable domestic stock. It includes all stocks with a primary listing on a major U.S. stock exchange; that are incorporated in the U.S. or have a major business presence there; that have a market cap of at least $10 million and at least 10% of shares publicly available; and that meet minimum trading requirements. While it includes real estate investment trusts, it excludes business development companies, American depositary receipts, royalty trusts, and limited partnerships. The CRSP market-cap segment indexes also incorporate banding and packeting, two techniques designed to limit unnecessary turnover. In general, it should correlate closely with other broad stock indexes. The fund employs full replication for the largest stocks and then samples from the remaining smaller-cap stocks. But because of its size, VTI is able to hold almost all of the securities in the index at nearly identical weightings, resulting in approximately 3,552 holdings compared with 3,571 in the index.

The fund charges just 0.05%, which is one of the cheapest total stock market funds available. While Schwab offers a broad-market fund for only 0.04%, VTI is not only more comprehensive, but it has beaten Schwab U.S. Broad Market ETF (NYSEARCA:SCHB) in costs in the past, and we expect that it will continue to do so in the future. In addition, VTI's greater trading volume and tighter benchmark tracking lead to lower trading costs when compared with SCHB. Still, SCHB is a compelling option, particularly for investors on the Schwab platform.

Alternatives
The aforementioned SCHB is probably the best alternative for VTI. It tracks an index that holds 2,500 securities, so it excludes micro-cap stocks. Also, SCHB engages in more liberal sampling of its index, while VTI is closer to full replication. iShares Russell 3000 Index (NYSEARCA:IWV), holds the 3,000 largest stocks, nearly as many as VTI, but IWV charges a higher 0.20%. iShares Core S&P Total U.S. Stock Market ETF (NYSEARCA:ITOT) tracks approximately 1,500 stocks from the S&P Composite 1500 Index, which does not delve as deeply into small- and micro-cap stocks as VTI.

Disclosure: Morningstar, Inc. licenses its indexes to institutions for a variety of reasons, including the creation of investment products and the benchmarking of existing products. When licensing indexes for the creation or benchmarking of investment products, Morningstar receives fees that are mainly based on fund assets under management. As of Sept. 30, 2012, AlphaPro Management, BlackRock Asset Management, First Asset, First Trust, Invesco, Merrill Lynch, Northern Trust, Nuveen, and Van Eck license one or more Morningstar indexes for this purpose. These investment products are not sponsored, issued, marketed, or sold by Morningstar. Morningstar does not make any representation regarding the advisability of investing in any investment product based on or benchmarked against a Morningstar index.

Source: The Quintessential U.S. Equity ETF