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This ETF and the S&P 500 make a good pair

Consider this low-cost exchange-traded fund to round out your U.S. equity exposure.

Adam McCullough, CFA 23 May, 2017 | 5:00PM
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 Vanguard Extended Market ETF (VXF) invests in nearly all U.S. stocks outside of the S&P 500. It efficiently tracks a well-diversified market-cap-weighted index at a low fee, which supports its Morningstar Analyst Rating of Gold.

The fund tracks the S&P Completion Index, which is designed to complement a large-cap U.S. equity holding, such as an index fund tracking the S&P 500. The fund primarily holds mid-, small- and microcap stocks, but it also includes a handful of large-cap names. The fund reaches further down the market-cap spectrum than most of its mid-cap peers and straddles the mid- and small-cap size segment breakpoint. Indeed, small-cap and microcap stocks make up over 50% of its holdings by weight. Because the index relies on others to accurately price its holdings, the fund is fully exposed to the potential excesses of the market. But it also reflects the collective views of active investors.

The fund uses representative sampling to effectively track its underlying index and mitigate transaction costs because smaller, less liquid stocks are usually more expensive to trade than large-cap stocks. Its broad market-cap-weighted portfolio promotes low turnover. Each stock's weighting in the index naturally moves with its price. Turnover has averaged 12% over the past 10 years -- a fraction of the average among its category peers. Low turnover and efficient tracking have paid off from a tax perspective; this fund has not issued a capital gain over the past decade.

For the 10 years through April 2017, the fund performed well, topping the average of its U.S.-listed peers by 1.5 percentage points each year with slightly more volatility. Its Sharpe ratio (a measure of risk-adjusted performance) landed in the top third of its peer group over the past decade. Its cost advantage and greater exposure to small- and microcap stocks were the biggest contributors to its outperformance.

Likely because the fund owns smaller stocks, its return on equity is consistently below the category average's. Its top 10 holdings represent less than 5% of its holdings, while the mid-cap blend category averages over 20%. Top holdings include large-cap stocks just outside the S&P 500, such as  Tesla (TSLA) and  Las Vegas Sands (LVS).

Most of the fund's sector weightings do not differ materially from the mid-blend category average. It has more exposure to the healthcare and consumer discretionary sectors but holds fewer technology and materials stocks compared with the mid-cap blend category. And most likely because this fund dips into smaller-cap stocks, its return on invested capital, a profitability metric, measured 2.3% compared with 8.5% for the category.

Portfolio construction

The fund diversifies risk and keeps turnover low by tracking the S&P Completion Index, a broad market-cap-weighted index that represents nearly every U.S. stock outside of the S&P 500, supporting its Positive Process Pillar rating.

The fund reduces transaction costs by sampling among the smallest, more illiquid stocks, but it still holds nearly every stock in the index. Relative to other indexes, the S&P 500 uses more restrictive criteria before adding a stock to the index, such as evidence of financial viability and that at least 50% of a company's shares float publicly. Since the S&P Completion Index is designed to be the complement of the S&P 500, it contains stocks that do not meet the S&P 500's inclusion criteria. Therefore, unlike most mid- or small-cap index funds, this fund contains a smattering of large-cap names, which can have an outsize influence on the portfolio, as they did in 2000.

Because the S&P 500 requires six to 12 months of seasoning before initial public offerings are included, the S&P Completion Index will hold IPOs sooner. Stocks added to the S&P 500 are removed from the Completion Index, and stocks dropped from the S&P 500 are added to the Completion Index if they still qualify for inclusion in S&P indexes. This fund minimizes its cash drag by using derivatives to equitize cash. Its cash balance averaged 0.5% over the past decade through April 2017. The average cash balance held by its peers in the category measured about 4% over the same time frame.

Fees

This fund levies a low fee of 0.08%, which is a fraction of the 0.88% median levied by its mid-cap blend category peers, meriting a Positive Price Pillar rating.

During the five-year period ended April 2017, the fund outperformed its benchmark by 9 basis points per year. This implies the fund has been able to more than offset some of the drag created by its fee through a combination of savvy portfolio management techniques and securities lending.

Alternatives

Canadian investors don't have many domestic options to obtain exposure to mid- and small-cap U.S. stocks. The U.S. Small/Mid Cap Equity category contains just two market-cap-weighted ETFs: iShares S&P U.S. Mid-Cap Index (XMC/XMH) and iShares U.S. Small Cap Index (XSU). The only alternatives are actively managed funds (which are plentiful but pricier) and ETFs listed in the United States.

Capturing the entire U.S. stock market in one fell swoop may be more appealing to investors. Those looking for this type of exposure might consider  Vanguard U.S. Total Market Index (VUN/VUS) or its U.S.-listed equivalent, Gold-rated  Vanguard Total Stock Market ETF (VTI). It tracks an index that covers virtually every U.S.-traded stock, not just those outside the S&P 500.

There is also iShares Core S&P U.S. Total Market Index ETF (XUU) and its U.S.-listed equivalent,  iShares Core S&P Total U.S. Stock Market (ITOT). The iShares fund follows the S&P Total Market Index, which is similarly broad as the CRSP index underlying the Vanguard offering. Both mandates have a comparable number of holdings and near-identical exposure from top to bottom down the market-cap spectrum.

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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.

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