Hard to Beat a U.S. Total Market Fund

U.S. stocks are the cornerstone of growth in an investment portfolio. That’s why it’s important to select the right fund. Most actively-managed U.S. stock funds don’t achieve the return of the S&P 500 and even fewer beat the entire stock market. This is why wise investors stop chasing active management and switch to a low-cost total stock market index fund.

Active fund managers tell us we can’t buy the market that they struggle to beat. That’s true, but we can get very close.

The Vanguard Total Stock Market Index Fund (VTSMX) has been around since 1992 and lower cost Admiral shares (VTSAX) have been available since 2000 ($10,000 minimum initial investment). There’s also an exchange-traded fund share class (VTI) with Admiral pricing and no minimum initial purchase.

VTSMX originally tracked the Wilshire 5000. It’s considered the broadest measure of U.S. listed stocks and currently holds over 3,800 securities. Vanguard switched benchmarks in 2005 to the MSCI US Broad Market. The MSCI Broad market covers about 3,300 stocks and represents about 99.5 percent of the US equity market by capitalization. That’s pretty close to a total market index fund.

In this article, I compared the 5-year annualized VTSAX return to actively-managed U.S. stock funds with the same investment objective. Using the Morningstar Principia database, updated through June 2012, I screened for funds that are classified under the Large Cap Blend Morningstar category and equity style box, have less than 10 percent in bonds and foreign securities, no index funds or enhanced index funds, and at least 5 years of return data.

There were 54 funds that met this criterion. It’s a smaller group than I expected, but all 54 funds and VTSAX are in the same appropriate peer group and I am trying to compare apples-to-apples.

Figure 1 illustrates the returns of the 54 surviving actively managed funds relative to VTSAX over 5 years ending in June 2012. The chart reflects the performance of each fund minus the return of VTSAX. Each column is a fund’s net outperformance or underperformance relative to VTSAX, which is set at zero percent. The 54 relative returns were then scaled from the lowest underperforming funds on the left to the highest outperforming funds on the right.

Figure 1: 5-Year Active Fund Performance Relative to VTSAX

Source: Morningstar Principia through June 30, 2012. Sales loads not included.

Seventy-eight percent of surviving active large blend fund performance fell below VTSAX over the 5-year period ending June 30, 2012.  The losers underperformed by 2.1 percent on average, and 6 funds underperformed by more than 4.0 percent annually.

Only 22 percent of surviving large cap blend funds outperformed VTSAX over the same period. The winners beat the index fund by an average of 1.1 percent, and 2 funds beat by more than 2.0 percent annually.

The relative returns of large cap blend funds during this 5-year period are slightly lower than their average rolling 5-year underperformance. The number of underperforming large blend funds varies from about 80 percent to about 50 percent depending on the decade. The data I compiled for The Power of Passive Investing finds that historically about two-thirds of surviving large cap blend funds underperformed an index fund alternative over multiple decades.

Sales loads charged for some active funds were not included in Figure 1, nor were funds that had closed or merged over the 5-year period. The relative performance would have been worse than what is shown in Figure 1 had sales loads and closed fund data been included. It should be noted that 10 of the 54 funds have a front-end sale loads that range from 3.0 percent to 5.75 percent.

Figure 2 compares the net fund expense ratios (ER) to 5-year returns, ending June 30. Fund ERs are on the X axis (bottom) and 5-year annualized returns are on the Y axis (left).

Figure 2: Comparing Fund Expense Ratios (ER) to 5-Year Performance

Source: Morningstar Principia through June 30, 2012. Sales loads not included.

I added a regression line to show the relationship between ER and fund performance. Generally, the funds with the highest ER have lower returns. Funds with the lowest ER were all above the average return although none had the highest return. The funds with the highest and lowest returns had an ER that was about average for the category (1.1 percent).

The case for using a U.S. total stock market index fund in your portfolio is powerful. It’s a low-cost, low-turnover way to capture your fair share of market returns. This idea works even better when it’s extended to a mutual fund portfolio covering several asset classes, and that’s the subject of my next article.