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By Michael Rawson, CFA

How does a boring old index fund achieve 4-star status? While it won't deviate from the category average as much as an actively managed fund, it has all the features typically associated with success, including good stewardship, low fees, and stable performance. Vanguard Mega Cap Index 300 ETF (NYSEARCA:MGC) charges just 0.13% and offers index-based exposure to giant- and large-cap stocks. These stocks have become bargains, particularly when compared with more-volatile small caps and intermediate-term bonds that offer a zero real return.

Suitability
MGC is an ideal core equity holding because of its low-cost, indexed-based approach. Its underlying stocks are widely diversified across both sectors and the value-growth spectrum. This fund is particularly well-suited for those seeking to precisely control their market-cap exposure, as it is designed to fit with Vanguard Mid-Cap ETF (NYSEARCA:VO) and Vanguard Small Cap ETF (NYSEARCA:VB) in order to cover the vast majority of the U.S. equities market with minimal holdings overlap.

The fund may lag the market in times of small- or mid-cap outperformance, but because it holds more than 70% of the market on an market-cap-weighted basis, the fund should be highly correlated to the broad market. In fact, the index that this ETF tracks, the MSCI Large Cap 300, had a correlation to the S&P 500 and the broader Russell 3000 Index of 99% during the past 10 years. The average market cap of $58 billion was greater than the $47 billion for the S&P 500. The MSCI Large Cap 300 Index had a volatility of return of 15.2%, slightly less than the 15.5% for the S&P 500. One way to interpret that risk number is to assume a normal distribution of returns. If we then assume a 6% expected future return, at least 16% of the time we can expect a return less than negative 9.2% (equal to one standard deviation below the expected return). While that level of risk is lower than the 20% standard deviation seen in small-cap stocks, it is still much higher than the 4% standard deviation in bonds.

Fundamental View
After strong performances in the late 1990s, U.S. large-cap equities have provided meager returns in the past 10 years despite representing some of the largest and most profitable companies in the world. While large caps have lagged, mid-caps, small caps, and emerging-markets stocks have outperformed. On a risk-adjusted basis, however, bonds have defeated all comers. The annualized 10-year return through August 2011 for the MSCI Large Cap 300 was up 2.5% while the S&P 500 was up 2.7%.

The strong economic recovery from the financial crisis appears to have slowed in mid-2011, as GDP growth stagnated and unemployment remained elevated. While forward-looking, sentiment-based indicators such as consumer confidence and purchasing-managers surveys point to a slowdown, which has caused stocks to sell off, earnings have remained strong. Valuations based on these strong earnings appear attractive with a price/earnings ratio of around 13 times. The dividend yield on the stocks in this fund of around 2.2% is higher than the yield on 10-year Treasury bonds. Morningstar analysts currently see the index constituents as undervalued, trading at a price/fair value of about 0.78. This is more attractive than mid-cap stocks, which they see as trading at a price/fair value of about 0.92. Not only are large caps relatively cheaper, they are also stabler. They see 46% of the weight of the index in stocks with a wide economic moat, which is a Morningstar measure of the quality and defensibility of a firm's competitive economic advantage.

Portfolio Construction
This fund tracks the MSCI Large Cap 300, a diversified capitalization-weighted index consisting of the 300 largest publicly traded U.S. companies. This fund covers the entire domestic large-cap universe and not just the giants, with only a fractional spillover into mid-caps. MGC holds nearly 90% of the S&P 500 by market capitalization, the excluded names mostly consisting of the S&P 500's modest mid-cap exposure. The major difference in portfolio construction apart from the number of stocks is that the MSCI index has no editorial input to select for company profitability or balance the sectors. This fund follows a full-replication strategy, holding every stock at nearly identical weights as the index, allowing the fund to track its index very closely.

Fees
This fund has a low expense ratio of 0.13%. While it has a lower estimated holding cost than SPDR (NYSEARCA:SPY), its market impact has been greater, suggesting that it is an ideal fund for buy-and-hold investors, but rapid traders will prefer the more liquid SPY.

Alternatives
Investors who want to include some exposure to mid-cap stocks should look at Vanguard Large Cap ETF (NYSEARCA:VV), which contains the largest 300 stocks plus the next 450. Investor who do not need to precisely control their large-, mid-, and small-cap exposures may prefer to hold Vanguard Total Stock Market ETF (NYSEARCA:VTI), which covers everything from mega-caps to micro-caps in a single, capitalization-weighted ETF. VV charges 0.12% while VTI charges just 0.07%.

IShares S&P 500 (NYSEARCA:IVV) tracks a broader list of 500 securities for just 0.09% while iShares S&P 100 Index (NYSEARCA:OEF) contains the largest 100 stocks from the S&P 500 and charges 0.20%.

Those looking for exposure strictly to mega-caps would be better off investing in SPDR Dow Jones Industrial Average (NYSEARCA:DIA), which tracks the 30 stocks in the Dow Jones Industrial Average and charges 0.18%. Those looking for quality should research Vanguard Dividend Appreciation ETF (NYSEARCA:VIG). With an expense ratio of 0.18%, it focuses on companies that have a 10-year track record of increasing dividends.

Disclosure: Morningstar licenses its indexes to certain ETF and ETN providers, including Barclays Global Investors (BGI), First Trust, and ELEMENTS, for use in exchange-traded funds and notes. These ETFs and ETNs are not sponsored, issued, or sold by Morningstar. Morningstar does not make any representation regarding the advisability of investing in ETFs or ETNs that are based on Morningstar indexes.

Source: Spotlight On Vanguard Mega Cap 300 Index ETF