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Welcome to the Stay Wealthy Podcast. I'm your host, Taylor Schulte. And today I'm talking about the benefits of owning market cap weighted index funds. Why? Well, last week I made a brief comment that there were some benefits to owning them and a number of you reached out and you wanted to know what those were.
So if like these other listeners, you're also curious about the benefits of market cap weighted index funds, today's episode is for you. For all the links and resources mentioned, head over to youstaywealthy.com forward slash 128.
So as a refresher, market cap weighted index funds are what most listeners are likely familiar with, whether you know it or not. For example, the Vanguard Total Stock Market Fund is a market cap weighted index fund. So is any plain vanilla S&P 500 fund like SPY or VOO or even a broad based international fund like IEFA, which is done by iShares.
In short, most passive index funds that you know by name are market cap weighted, which as shared last week means that companies with larger market capitalizations get a higher allocation in the fund.
As I also shared last week to help highlight what this actually means to us as investors, the top 10 holdings in the Vanguard S&P 500 Index Fund currently make up about 30% of the entire fund, with names like Apple, Microsoft, and Google, i.e. the largest companies, at the very top.
As those companies get bigger and bigger, so does your ownership of them. In plain English here, with a market cap weighted index fund, most of your money is being invested in the largest companies and less of your money is being invested in smaller companies, even if those smaller companies are high quality, appear to be trading at attractive prices, and have higher expected future returns.
Unfortunately, a company's stock price and market capitalization can deviate wildly from its true underlying value. In other words, just because a company is large doesn't necessarily mean it's always a good investment to own. We saw this with General Electric not that long ago when details on what was going on behind the scenes finally surfaced and from top to bottom, the stock dropped 80% from all-time highs.
While I don't think that market cap weighted index funds are the absolute most prudent way to invest and that there are better methodologies to consider using when constructing a global portfolio, they do provide enough of a benefit to make every investor at least consider dedicating a portion of their portfolio to them.
There are three reasons why. The first is cost. Market cap weighted index funds like Vanguard's total stock market fund, VTI, they tend to be lower cost than funds that use a more advanced methodology.
They also have lower turnover, which means fewer buying and selling of stocks inside the fund, which in turn reduces transaction fees that are usually passed down to you, the investor. So, for example, VTI, the Vanguard Total Stock Market Index Fund, it has an expense ratio of 0.03%.
Whereas the Vanguard multi-factor ETF, the ticker is VFMF, has an expense ratio of 0.19%, 500% more expensive.
The multi-factor ETF is more expensive because it uses a more advanced quantitative model to construct the portfolio, and it requires more ongoing maintenance by the ETF manager. It's still a rules-based model, i.e. there isn't a person that is actively deciding what stock to buy and sell every day.
But Vanguard still acknowledges on their website that this ETF structure is a form of active management. And by the way, active management gets a lot of bad rap, but it's not necessarily because active fund managers aren't good at what they do. Many of them are. It's usually because the fees that they charge to the investor are excessive and they eat away at any of the additional returns that they might create.
Low fee rules based active management, which is essentially what companies like Dimensional Funds, Avantis, Alpha Architect and now Vanguard are providing. It creates a lot of opportunity for long term investors to get smarter about portfolio construction without paying an arm and a leg to do it.
That said, it's only fair to acknowledge that these solutions are still more expensive than your plain vanilla market cap weighted index fund. And fees are a pretty good predictor of future returns. So having an allocation to a fund like Vanguard's total stock market ETF is a simple way to get broad exposure at a very low price, almost free and reduce the weighted average of your entire portfolio, the weighted average cost.
The second benefit is momentum. Momentum is the rate of acceleration of a security's price and many investors and even the media use momentum to measure the overall sentiment of the market or even an individual company. Taking it a step further, momentum trading is a strategy that tries to capitalize on the momentum of a particular trend that seems to be gaining traction or even a company or a sector that's experiencing accelerating earnings or revenues.
Instead of the old adage, buy low, sell high, momentum traders might say something like buy high and sell even higher. And believe it or not, there's actually some academic merit to this sort of investing approach. In fact, the Vanguard multi-factor fund that I just referenced uses momentum as one of its factors for constructing the portfolio.
So what does this all have to do with market cap weighted index funds? Well, market cap weighting, some would argue, is a form of a momentum strategy. As companies get bigger and more successful, you end up owning more and more of them. And this can work out really well in a lot of scenarios. For example, last year in June on this podcast or right around then, I shared that the five largest stocks in the S&P 500 had returned a positive 35% year to date.
That was Facebook, Amazon, Apple, Microsoft, and Google. So year to date, last year, halfway through, just those five stocks alone in the S&P 500 returned 35%.
Well, the other 495 companies in the S&P 500 during that same time period had a negative return of 5%. A market cap weighted investor who had most of their money and the largest US companies in their Vanguard S&P 500 index fund, they were pretty happy about that allocation.
Now, the point of today's episode was to talk about the benefits of market cap weighting. So I want to be careful not to let the negatives overshadow here. But it's important to note that this does work the other way around, too. For example, leading up to the tech bubble, one could say tech stocks were gaining a lot of momentum. And they were. Everyone and their grandma was buying tech stocks and making a lot of money doing it.
So was Vanguard. In fact, the Vanguard Total Stock Market Fund, at the height of the tech bubble, right before it burst, had almost 40% of its assets in tech stocks. Similarly, just before the crash in 2008-2009, the Vanguard Total Stock Market Fund had its highest exposure to financials and energy stocks.
All of that being said, having an allocation to a market cap weighted fund does allow you to ride the momentum of the markets without any sort of bias or intervention. The movements are simply driven by the collection of investor behaviors and choices on any given day. And as I've shared before on this podcast, the wisdom of crowds is powerful and many times incredibly accurate. And we might just want a slice of that wisdom in our portfolio.
This segues nicely into benefit number three with a hat tip to the late John Bogle, and that is that you are also minimizing speculation with a market cap weighted fund like the Vanguard Total Stock Market Fund. You're on both sides of every speculative trade. You own the entire stock market without bias, and you don't care who wins or loses each day.
With just about any other index or factor methodology, value, size, quality, you name it, you're on one side or the other.
As John Bogle said, invest, don't speculate. And that's what a market cap weighted fund does. It minimizes speculation and it just invests your money. Since 1926, on average, the S&P 500, a market cap weighted index, has generated average annual returns of just over 10%. And that's hard to complain about that type of historical performance most of us would take.
Could you have done better by taking a multi-factor approach instead during that same time period, i.e. increasing your allocation to companies that were small, cheap, and profitable? Absolutely. But would you have had the patience and discipline to maintain that approach through the good times and the bad?
I ask that because those factors don't always go up with the broad markets and sometimes they underperform for long periods of time. Just look at value stocks for the better part of the last 15 years. So in addition to minimizing speculation, we could also argue that dedicating at least a percentage of your portfolio to market cap weighted funds
might be beneficial from a behavioral perspective, helping you stay invested over the long term, which we all know is the most important ingredient to finding success with investing.
To summarize and bring us home here, market cap weighted index funds, they have their benefits and likely deserve a place as a core position in your portfolio. But they do have enough drawbacks that personally steer me away from putting 100% of my money and my client's money in them, especially in an environment where the broad markets appear overbought and overvalued. And there are asset classes with higher future expected returns that I would want to have an allocation to.
For all the links and resources mentioned today, head over to youstaywealthy.com forward slash 128. Thank you as always for listening, and I will see you back here next week. This podcast is for informational and entertainment purposes only and should not be relied upon as a basis for investment decisions. This podcast is not engaged in rendering legal, financial, or other professional services.