In hopes of capturing more dollars, companies big and small love to boast they offer one-stop shopping. Investing is no different. Vanguard, for example, has a one-stop offering for investors who want to simplify their exposure to the U.S. equity market: the Vanguard Total Stock Market Index fund. It tracks the return of the MSCI U.S. Broad Market Index.

This type of fund is certainly convenient, but is it the best approach for U.S. stock market exposure, the heart of many clients' investment portfolios? Another approach would be to invest in separate index funds from the large-cap, mid-cap and small-cap sectors represented in the Total Stock Market Index. Assume those separate funds are Vanguard 500 Index Investor (a proxy for the S&P 500), Vanguard Mid-Cap Index and Vanguard Small-Cap Index. Vanguard Mid-Cap attempts to mimic the MSCI U.S. Mid-Cap 450 Index, while Vanguard Small-Cap tracks the MSCI U.S. Small-Cap 1750 Index.

When combined, these three funds should accomplish - at least in theory - what the Total Stock Market Index seeks to achieve. So which performed better: the single mega-fund or the three specialized funds from Jan. 1, 2001 to Dec. 31, 2010?

 

THE MARKET-CAP QUESTION

The "Sizing It Up" chart, above, shows the annual returns of the three core indexes. Over the past 10 years, the mid-cap and small-cap index funds dominated the larger-cap Vanguard 500 Index Investor. Small-cap bested large-cap in nine of 10 years, while mid-cap beat large-cap in eight of 10 years.

If you are combining these three index funds to form a homegrown total stock market index, the biggest question is allocation. Vanguard Total Stock Market is about 70% large-caps, 20% mid-caps and 10% small-caps, according to Morningstar. This allocation represents a weighting that generally reflects overall market capitalization of the U.S. equity market. But rather than using market-cap weighting, assume equal weighting of the three separate index funds, producing a total U.S. stock market allocation that's one-third large-cap, one-third mid-cap and one-third small-cap.

As with roughly all U.S. equity indexes and index funds, Vanguard Total Stock Market Index is an accurate reflection of a capitalization-weighted equity market. Weighting a portfolio according to market cap will, of course, allow large-cap stocks to dominate the performance.

But if your goal is to gain exposure to the unique return patterns of large-, mid- and small-cap U.S. stocks, a three-index approach may be a better solution (see the "Three on One" chart, below).

 

POWER OF THREE

Using a combination of three index funds to gain exposure to the U.S. equity market produced a 10-year annualized return of 5.2% compared with 2.5% for the mega-index approach using Vanguard Total Stock Market Index. Assuming a lump-sum initial investment of $10,000, this performance differential translated to an ending account value that was nearly $4,000 higher.

During the seven years in which the U.S. equity market had positive returns, a three-fund approach had better performance five times (or more than 70% of the time). In two of those five years, the performance differential was 500 basis points or more.

In addition, the equally weighted three-fund approach performed better during two of the three years in which the S&P 500 had negative returns in this 10-year period. In 2001, the Total Stock Market Index lost 11%, while the three-index strategy was down just 3.1%. In 2002, the single fund tumbled 21%, while the three funds combined lost 19%. Performance during the third bear market, in 2008, slightly favored the total stock market index fund (-37% vs. -38.3%).

 

RISK ASSESSMENT

The difference in risk as measured by standard deviation between these two approaches was minimal. In fact, the slightly higher standard deviation for the three-fund approach was largely a result of the fact that it generally had higher positive returns. Investors don't react badly to that cause of higher standard deviation.

Another advantage of a three-fund approach is that the performance is separable. In other words, the total stock market index fund produces one return. If the return in a particular year is negative and clients need to withdraw funds - too bad. Their withdrawals will magnify the loss of the fund that year. By contrast, a three-fund approach produces three separate returns, and not all of them might be negative in bear market years.

For example, in 2001 the total stock market index fund lost 11%, while the three-fund approach lost 3.1%. But the small-cap index fund actually had a gain of 3.1% that year. So if a client needed to take a withdrawal, he or she could take it from the small-cap index, leaving the other two index funds untouched and not realizing the losses.

Some advisors may feel that equally weighting the three separate index funds creates more risk by over-allocating to mid- and small-cap stocks. It's true that the standard deviation for the mid- and small-cap funds is slightly higher than the large-cap fund - but is the difference material? Do investors relate in a meaningful way to standard deviation, or to absolute downside returns?

The answer may be the latter. The small-cap index had better downside performance than the large-cap index in 2001, 2002 and 2008. Interestingly, the small-cap index also had better performance than the total stock market index in those same three bear market years.

What happens if the three separate indexes are combined in a market-cap allocation (70% to large-cap, 20% to mid-cap and 10% to small-cap)? Interestingly, the 10-year annualized return is 50 basis points higher than Vanguard Total Stock Market Index, with a nearly identical standard deviation.

 

TALE OF THE TAPE

Gaining exposure to U.S. stocks by using three equally weighted index funds produced better performance than a single mega-market index fund during the Lost Decade of 2001 to 2010. The difference in risk between the two approaches is immaterial because the three-fund approach actually had better performance in two of the three bear market years.

Whether you decide to allocate equally among three separate index funds or in a market-cap-weighted manner, the results are better than a single total stock market index fund. Divide and conquer.

 

Craig L. Israelsen, Ph.D., an associate professor at Brigham Young University in Provo, Utah, is the author of 7Twelve: A Diversified Investment Portfolio with a Plan.