By Michael Rawson, CFA
Vanguard Extended Market Index ETF (NYSEARCA:VXF) is an ideal supplement to a large-cap portfolio as it is designed to be paired with an S&P 500 Index fund. This fund tracks the S&P Completion Index, which holds virtually every liquid U.S. stock outside of those in the S&P 500 Index.
Filling the gaps in the S&P 500 means that the fund holds a handful of large-cap names that are not in the S&P 500, such as Facebook (NASDAQ:FB) and Las Vegas Sands (NYSE:LVS). These include companies that don't meet the S&P 500 Index's 50% public float requirement, companies that don't meet the index's domicile requirement, and recent initial public offerings that don't meet its six to 12 month seasoning requirement. The charts below graph the weightings of the largest 3,500 stocks in the S&P 500 and the S&P Completion Index ranked from largest to smallest. A few things stand out when looking at these charts. The first is the skew of the S&P 500 toward mega-cap stocks. The second is that the S&P Completion Index has most of its weight in the smaller stocks toward the right-hand side of the chart. It is also apparent that the S&P Completion Index includes a smattering of larger names that are absent from the S&P 500 for the reasons outlined above. That said, the majority of the Completion Index consists of mid- and small-cap names and is rounded out with a decent chunk of micro-cap stocks.
The result is that the Completion Index's portfolio behaves very similarly to a mid-cap index fund. In fact, since the Completion Index's inception nine years ago, it's had a 99% correlation to the Morningstar Mid Cap Index. Investors who pair this fund with an S&P 500 Index fund or ETF such as Vanguard S&P 500 ETF (NYSEARCA:VOO) effectively gain exposure to the total U.S. stock universe. A passive allocation to U.S. equities would hold a 78% position in an S&P 500 Index fund and 22% in this fund.
The S&P 500 Index and the S&P Completion Index have had a 95% correlation since the Completion Index's inception, so the diversification benefits are minimal. That said, mid-and small-cap stocks tend to be riskier as they exhibit greater sensitivity to macroeconomic risks and they typically lack economic moats, or sustainable competitive advantages. The greater risk in smaller stocks is evident in their volatility. Since inception, the standard deviation of monthly returns of the index that this fund follows was 19.4%, compared with 15.4% for the S&P 500 Index. With this greater volatility comes a higher beta and the expectation for higher returns to compensate for heightened risk. Over that same time period, the Completion Index returned 8.94% on an annualized basis compared with 6.66% annualized for the S&P 500.
For investors looking for an all-encompassing passive allocation to U.S. stocks, we recommend a single fund such as Vanguard Total Stock Market ETF (NYSEARCA:VTI) or iShares Core S&P Total US Stock Market ETF (NYSEARCA:ITOT). Those already holding an S&P 500 fund looking to round out their portfolio with mid- and small-cap stocks are faced with a choice: either add a fund tracking a completion index such as this, resulting in two positions, or sell the S&P 500 fund and allocate the proceeds to a total market fund, resulting in just one holding. Holding the entire stock market in just one fund eliminates the need to rebalance as stocks migrate from one market-cap size segment index to another, and in the case where mid-caps outperform large caps. However, if selling the S&P 500 fund would result in capital gains taxes, investors are likely better off with the two-fund approach.
This fund tracks the S&P Completion Index, which contains all of the liquid securities on the NYSE and Nasdaq that are not components of the S&P 500 Index. While the index holds about 3,260 securities, the fund holds about 3,060. With that level of replication, tracking error has been minuscule. The fund delves deeper into micro-cap territory than the S&P 1500 Index. The average mid-blend fund has an average market cap of $7.0 billion and virtually no micro-cap exposure, whereas this fund has an average market cap of $3.0 billion and a nearly 14% stake in micro-cap stocks. To the extent that the S&P 500 Index has a slight quality tilt, this portfolio would have the opposite tilt since it is the complement of that index. Any stock being added to the S&P 500 will be removed from this index, and vice versa.
This ETF charges 0.10%. That beats the 1.18% fee levied by the average mid-blend fund as well as the 0.40% average fee charged by the average mid-blend ETF. Although there are no perfect ETF alternatives to this fund, there are a couple of index mutual funds that track completion indexes. Fidelity Spartan Extended Market Index Investor (FSEMX) shares carry a 0.10% expense ratio and require a $2,500 investment. Vanguard Extended Market Index Admiral (VEXAX) is the mutual fund share class of VXF, but it requires a $10,000 minimum investment.
Those looking for more-focused mid-cap exposure might consider iShares Core S&P Mid-Cap (NYSEARCA:IJH) at 0.15%, which tracks the next 400 largest stocks after the S&P 500. Those looking for a total market fund might consider Vanguard Total Stock Market ETF (VTI), which charges an annual fee of just 0.05%.
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.