Spring cleaning: Use this ETF to simplify your U.S. equity allocation

A one-stop holding for broadly diversified exposure to the U.S. stock market at a low price.

Adam McCullough, CFA 1 May, 2018 | 5:00PM
Facebook Twitter LinkedIn

iShares Core S&P U.S. Total Market ETF (XUU) is a great option for diversified exposure to U.S. stocks of all sizes. The fund keeps costs down by leveraging BlackRock’s portfolio management infrastructure and expertise in the United States by investing directly in its U.S.-listed market-cap weighted funds. A low management expense ratio and representative index leave the fund positioned to produce attractive risk-adjusted returns over the long haul. It earns a Morningstar Analyst Rating of Gold.

The fund tracks the S&P U.S. Total Market Index, which holds nearly every investable U.S. stock, including micro-caps. Because of regulations on diversification in the United States, the fund achieves its exposure by investing in several U.S.-listed funds instead of the fund's U.S. equivalent, iShares Core S&P Total U.S. Stock Market ETF (ITOT). Its market-cap-weighting approach reduces turnover because changes in the market value of its holdings mirror changes to their weightings in the market.

Broad diversification is an intrinsic advantage of funds tracking market-capitalization-weighted total stock market indexes. Market-cap weighting can be a beneficial approach in momentum-driven bull markets, but it can also lead to significant sector and single-security concentration, as witnessed at the height of the technology bubble. A total market fund such as this is a better approach for a passive equity allocation than combining separate size segment funds because it covers the full market-cap range and isn’t forced to trade stocks as they move across market-cap segments.

Because this fund tracks the entire U.S. equity market, its performance should be similar to that of the average investor, before fees. But its low fee of 0.08% gives the fund a large and sustainable edge over the average U.S. Equity fund; its closest competitor,  Vanguard U.S. Total Market ETF (VUN), charges twice as much. From its inception in February 2015 through March 2018, the fund outpaced the category average return by 2.4 percentage points with lower volatility. But the fund can carry meaningful risk. Although this fund has a short live performance record, its U.S.-listed equivalent fell more than its average peer during the bear market from October 2007 through March 2009. The fund stays fully invested all the time, so it won’t miss a rally, but it exposes investors to the full brunt of market downturns.

Fundamental view

Broadly diversified, market-cap-weighted index funds like this one derive a persistent 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).

However, the fund's market-cap-weighted portfolio can lead to large positions in a few sectors and mega-cap stocks. While the portfolio is currently well-diversified, it has experienced high sector concentration in the past. For example, the technology sector represented about a third of the S&P 500 during the tech bubble in the late 1990s. But this risk is a small price to pay for the efficiency and cost advantage gained from market-cap weighting.

Although the fund relies on others in the market to set the prices and weightings of its holdings, it benefits from low turnover and transaction costs. Market-cap-weighted index funds are also cheaper to run than most actively managed funds because they require fewer investment personnel. If the fund sponsor passes on the economies of scale to fundholders through lower management fees, as this fund does, then investors benefit from a low fee hurdle to clear each year.

Market-cap-weighted index funds carry lower cash balances than their actively managed counterparts, which helps performance during bull markets but detracts during bear markets. Its U.S.-listed equivalent lost 55 percentage points during the bear market from October 2007 through March 2009, slightly more than the average large-blend fund during this time period. But because index funds stay nearly fully invested, they won't miss the upside. The U.S. fund's cash balance averaged only 0.1% for the decade through March 2018 -- a tiny fraction of its average peer's cash balance over this period.

The fund owns stocks of all sizes, but its market-cap-weighting approach pulls its portfolio toward the largest U.S. stocks. The fund's average market cap is slightly lower than the category average. The fund's sector weightings do not differ much from the category average, but it has a slightly higher weighting in technology stocks. While it skews toward the largest U.S. stocks, the fund does invest in small stocks without sustainable competitive advantages. As of this writing, 47% of this portfolio is invested in companies with Morningstar Economic Moat Ratings of wide compared with 55% for the average fund in the category. This goes hand in hand with the fund diving lower down the market-cap spectrum than the average fund in the category and may slightly increase its risk. But that risk may compensate investors with higher returns and is largely mitigated by the fund's broad diversification.

Facebook Twitter LinkedIn

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.

© Copyright 2024 Morningstar, Inc. All rights reserved.

Terms of Use        Privacy Policy       Disclosures        Accessibility