Round out your large-cap U.S. stock fund with this ETF

This well-diversified offering pairs well with the S&P 500.

Adam McCullough, CFA 18 September, 2018 | 5:00PM

Mid- and small-cap stocks are usually riskier investment propositions than their large-cap brethren. They tend to have less-established competitive advantages and are more sensitive to the economic cycle. But they offer diversification benefits and may compensate investors with higher returns.  Vanguard Extended Market ETF (VXF) is an excellent choice for exposure to U.S. stocks that land outside of the S&P 500. This fund achieves a leg up over its peers by efficiently tracking a broadly diversified index at a low fee. It earns a Morningstar Analyst Rating of Gold.

The fund tracks the S&P Completion Index, a broad market-cap-weighted index that represents nearly every U.S. stock outside of the S&P 500. Market-cap weighting skews the fund toward the index's largest names, but it reaches further down the market-cap spectrum than most mid-cap U.S. equity funds and straddles the mid- and small-cap size segment breakpoint. Indeed, its average market capitalization is about half of the category average. The fund's broad reach and market-cap weighting should help it effectively diversify firm-specific risk.

By using market capitalization to weight its holdings, the fund relies on the cumulative knowledge incorporated in stock prices to size its positions. While market participants have done a good job valuing stocks over the long term, the market has gone through episodes of mania and panic. But this risk is worth the cost advantage gained from market-cap weighting. Market-cap-weighted index funds are cheaper to run than most actively managed funds because they require fewer investment personnel and their low turnover translates to low transaction costs. The fund's turnover during the past decade measured a fraction of the average fund in the category.

The fund further reduces its turnover by using representative sampling to effectively track its underlying index. Smaller, less-liquid stocks are usually more expensive to trade than large-cap stocks. The fund keeps costs down by sampling among the smallest stocks in the index while maintaining an accurate representation of its characteristics.

During the trailing decade through July 2018, the fund has performed well, topping the category average by 2.4 percentage points each year with slightly more volatility. Its cost advantage and greater exposure to small- and micro-cap stocks were the biggest contributors to its outperformance.

This fund levies a low fee of 0.08%. During the trailing three years through July 2018, the fund outpaced its benchmark by 13 basis points per year. This implies the fund has been able to more than offset the drag created by its fee through a combination of savvy portfolio-management techniques and securities lending.

Fundamental view

Broadly diversified, market-cap-weighted index funds, like this one, earn a durable edge from efficient portfolio construction. The fund's broad, market-cap-weighted portfolio accurately represents its peers' opportunity set. Stock prices, which drive the fund's weightings, quickly incorporate new information and reflect the collective wisdom of the market (or madness of the crowd).

There are some drawbacks to market-cap weighting. By design, market-cap weighting increases the fund's exposure to stocks as they become larger and more expensive, and reduces its exposure to names as they become smaller and cheaper, which may have higher expected returns. Index funds also remain fully invested. Staying fully invested reduces the fund's cash drag and helps performance during bull markets, but provides less cushion during market downturns.

Although the fund relies on others to set the prices and weightings of its holdings, it benefits from low turnover and transaction costs that outweigh the drawbacks of market-cap weighting. The Vanguard portfolio management team uses representative sampling among the smallest stocks in the index to further reduce turnover and transaction costs. The fund would likely incur unnecessarily high transaction costs to fully replicate the index because the index delves far down the market-cap spectrum, and small stocks are more expensive to trade than large names. Instead, the portfolio managers sample among the smallest names to avoid trading them when it doesn't materially affect the characteristics of the fund. During the past decade through 2017, this fund's turnover measured just 11% compared with 79% for the average fund in the category.

Market-cap-weighted index funds carry lower cash balances than their actively managed counterparts, which helps performance during bull markets but hurts it during bear markets. For example, this fund lost 58 percentage points during the bear market from October 2007 through March 2009, slightly more than the average fund during this period. But because index funds stay nearly fully invested, they won't miss the upside. From the trough of the bear market in March 2009 through July 2018, this fund returned 20.3% annually compared with 18.2% for the average fund in the category.

The fund's higher ownership of smaller stocks likely led to its slightly higher risk than the category average over the past decade through July 2018. But the fund's broad diversification should help mitigate firm-specific risk. Its market-cap-weighting approach skews the fund toward the largest stocks excluded from the S&P 500. (Because the fund contains stocks that do not meet the S&P 500's strict inclusion criteria, it contains a smattering of large-cap names) Its portfolio straddles Morningstar's mid- and small-cap size segments. And the fund's average market capitalization is about one third that of the mid-cap blend's average.

Most of the fund's sector weightings are comparable to the category average. As of this writing, the fund has slightly more exposure to stocks in the real estate and healthcare sectors, but holds fewer materials sectors stocks. And most likely because this fund dips into smaller-cap stocks, it tends to invest in less-profitable companies than most category peers.

About Author

Adam McCullough, CFA

Adam McCullough, CFA  Adam McCullough, CFA, is a manager research analyst for Morningstar Research Services LLC, a wholly owned subsidiary of Morningstar, Inc. He covers passive strategies.