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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 0.12% 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.

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 $70 billion was greater than the $56 billion for the S&P 500. The MSCI Large Cap 300 Index had a volatility of return of 15.5%, slightly less than the 15.9% 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 9.5% (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
Austerity measures in response to the European sovereign debt crisis and slower growth in emerging markets have stoked fears of a global economic slowdown. First-quarter economic growth in the U.S. was revised lower to 1.9% while job growth appeared to slow from the rapid pace of improvement seen during the winter months. In the meantime, earnings in the U.S. have held up remarkably well. Currently, analysts are expecting operating earnings on S&P 500 stocks to hit $105 in 2012, putting the S&P 500 at an attractive forward price/earnings ratio of 12.5 times. The 2.4% dividend yield on the stocks in this portfolio is higher than the 1.6% yield on the 10-Year U.S. Treasury Note. However, not all valuation measures look compelling. The Shiller PE, which uses 10-year average earnings, is actually above its long-term average.

After strong performance in the late 1990s, U.S. large-cap equities have provided meager returns over 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, but, on a risk-adjusted basis, bonds have beat all comers. The annualized return for the MSCI Large Cap 300 Index over the past 10 years was 4.7% per year about the same as the S&P 500. On an asset-weighted basis, our stock analysts assign a price/fair value on this ETF of about 0.86, while the price/forward earnings ratio is 12 times. Furthermore, 57% of the fund is invested in giant-cap stocks, which tend to be better diversified and have wider economic moats, Morningstar's measure of sustainable competitive advantage. The fund has 46% of its assets in wide-moat stocks compared with 43% for the S&P 500. Additionally, dividend yields are better than intermediate-term bond yields, a situation that bodes well for the valuation of stocks relative to bonds. We feel that given the reasonable valuation and low volatility, particularly compared with small caps, now is a good time to buy this or a similar fund.

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 0.12%. While it has a lower estimated holding cost than SPDR S&P 500 (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 0.10% while VTI charges just 0.06%.

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 0.17%. Those looking for quality should research Vanguard Dividend Appreciation ETF (NYSEARCA:VIG). With an expense ratio of 0.13%, it focuses on companies that have a 10-year track record of increasing dividends.

A version of this article appeared on Oct. 6, 2011.

Disclosure: Morningstar licenses its indexes to certain ETF and ETN providers, including BlackRock, Invesco, Merrill Lynch, Northern Trust, and Scottrade 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.

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