In my last article, I challenged the passiveness of the S&P 500 and argued that it is actually a quite active bet on US large caps. However, I only mentioned briefly how investors can get truly passive exposure to the US equity market (with “truly”, I mean as close to the theoretical ideal as practically possible). This will be the main topic of this follow-up and I will specifically look at the Vanguard Total Stock Market ETF (NYSEARCA:VTI). There are of course also some competing funds, for example the iShares Core S&P Total U.S. Stock Market ETF (ITOT). I may cover those in a future article.
What is passive investing and why should you do it?
Passive investing mostly comes from academia. The idea emerged from a large body of research over the last decades and it is impossible to give all relevant references. The most important ideas, however, are Markowitz’ portfolio theory, Tobin’s two-fund separation, the Capital Asset Pricing Model (CAPM), and a large body of empirical work on the (poor) performance of actively managed mutual funds. As I mentioned last time, going into more academic details is beyond the scope of such an article and probably not interesting to non-finance-nerds like me. Therefore, let’s jump to the definition of passive.
Passive investing means holding the market portfolio, i.e. the portfolio that contains all available risky assets in proportion to their market value. Not more, not less. This is obviously a rather theoretical concept. I know no one who really holds a value-weighted slice of all assets in the world. However, we can apply the idea of the market portfolio to every asset class or region.
With respect to equities, passive investing therefore means holding all stocks weighted by their market capitalization. In danger of confusing you further, you already see that from this global perspective, VTI is still an active fund. Why? Because you don’t hold all stocks in the world but only those from the US. But as the title suggests, we will examine in this article how you can get truly passive exposure to the US market. So let’s forget about international markets for a moment. As it turns out, VTI is a very good instrument for that purpose.
Before we continue, two short comments on why there are compelling reasons to invest (at least some fraction of your assets) passively. The first is diversification. By holding all available assets within a certain geography or asset class, you are probably well diversified. For most people, often including myself, this is a good thing. To successfully run a concentrated portfolio you need to have some form of competitive advantage over other investors. Without, you shouldn’t expect to outperform. As Warren Buffett famously said, the first rule of investing is to not lose what you have and diversification helps to do that. To anticipate any comments in that direction: I don’t fully subscribe to the efficient market hypothesis. However, I do believe in diversification (even for active strategies) and I think you should only place active bets when you have a demonstrable competitive advantage to do so.
The second reason is that you have the odds on your side. In his popular paper The Arithmetic of Active Management, Nobel laureate Bill Sharpe shows that you should expect the average active manager to underperform the passive benchmark by the amount of fees they charge. This of course doesn’t mean that all active managers are bad (the paper has been challenged accordingly). However, a lot of empirical studies show that most active managers indeed underperform and only very few consistently beat their benchmark. Again, I am not a fully efficient-marketer and I believe that skilled managers exist. But finding them ex-ante is difficult and requires time and resources. Going passive is therefore a fully reasonable choice for those who don’t want (or don’t can) play this game.
With that in mind, let’s see how VTI implements passive exposure to the US stock market.
The total US market vs. the S&P 500
To passively invest in US equities, we need a market cap-weighted portfolio of all US stocks. As you can already see from this sentence, this cannot be the S&P 500. Instead, VTI tracks the CRSP U.S. Total Market Index. CRSP stands for Center for Research in Security Prices and is among the best financial data providers in the world. More importantly, CRSP is an affiliate of the University of Chicago. As most of you probably know, the University of Chicago and its outstanding scholars was (and still is) instrumental in the world of academic finance and strongly contributed to the adoption of passive investing in the industry. What I want to say with this: you probably don’t get a more intellectually honest index provider than CRSP for a passive product. In my opinion, that’s a clear positive for VTI.
In addition to that, there were rumors that CRSP’s index-fees are lower than those of other providers like MSCI when Vanguard switched the index provider in 2012 (see for example here). If passed through to investors, lower index-fees mean lower expense ratios which are exactly the business practices we know from Vanguard (more about the index market here).
The CRSP Index currently consists of slightly more than 4,000 US stocks. According to CRSP, that covers nearly the entire investable US market as opposed to “just” 80% for the S&P 500. You also see this from the active share of the S&P 500 with respect to the CRSP Index. Based on my calculations, the active share currently stands at about 15% which indicates a lot of similarities but also highlights the slightly active character of the S&P 500 (the higher the active share, the more passive the strategy). But enough with the theory, let’s look at the return of both indices for the longest common period since 2013.
Over the last 10 years, the CRSP Index somewhat lagged the S&P 500. In total, it underperformed by 14%-points or 52 basis points per year. What does this mean? Well, first and foremost, it means that the active bet on the S&P 500 large caps paid off. By construction, the CRSP Index holds everything and small and mid caps underperformed during this period. The next chart shows this via the performance gap between the S&P 500 and the Russell 2000, a common proxy for US small and mid caps (please don’t ask me why the performance of the S&P 500 is different in the second chart, I selected the same period… you still see the gap).
Bottom line: passive investing means holding everything. This can be psychologically difficult when you underperform seemingly passive strategies like the S&P 500 for a decade or longer. However, it is the nature of diversification that some things are above and some are below average. Anything else would be called alpha…
Investing in the US market via VTI
So far, we concluded that the CRSP Index is a good benchmark for the entire US market. The final (and rather easy) question is whether the VTI ETF is a reasonable instrument to track this index.
In my opinion, the answer is yes. Vanguard is this special company built to deliver cheap market exposure to investors and they fully deliver on that promise with VTI.
As the chart above shows, there is virtually no difference between the performance of the investable fund and the index. In fact, over the depicted period, the fund was even slightly better than the index. The fund comes with an extremely low fee of 0.03% and tremendous scale ($1.2T AuM). In addition to that, Vanguard is famous for its strong integrity and investor-friendly business practices. In my opinion, VTI is therefore the best instrument to invest as passive as possible in the US market.
Finally, let me briefly comment on my motivation behind these articles on passive investing. Some of you may criticize that I am way too meticulous and I can totally understand that. In the end, ETFs are some kind of commodities and differences in tracking errors, performance, or fees usually amount to only few basis points a year (they still add up over long periods!). If my articles save you those basis points, that’s a nice side effect but not my main motivation. What I would like to achieve is that people know what they are doing. I always try to follow Warren Buffett’s advice and only invest in things that I understand. Unfortunately, I see many people who blindly go into an S&P 500 ETF and describe themselves as passive. Even worse, some people equate ETFs with passive investing altogether (remember that ARKK is also an ETF; do I really need to say that it is not passive?). Don’t get me wrong, there are many worse investments than the S&P 500 (ARKK, for example) and the index remains a reasonable proxy for the US market. But if you intend to be truly passive, you should go with a total market ETF like VTI. Everything else is an unintended active bet and/or just a proxy for the true passive market portfolio.
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