Thesis
Our overview of the current stock market (that is, the S&P 500 index) can be summarized in two words: very expensive. We will explain why we formed this view in more detail a bit later. Against this background, the goal of this article is to explain A) what are the differences between the Vanguard Total Stock Market ETF (NYSEARCA:VTI) and the S&P 500 index, and B) why VTI can offer some advantages because of these differences.
The essence of our argument can be summarized in one sentence: the inclusion of mid and small-cap companies in VTI provides exposure to higher growth potential at a potentially lower valuation compared to the S&P 500 index. As such, we think VTI can help mitigate risk and provide a well-rounded portfolio for investors under current conditions. In the remainder of this article, we will elaborate on these points.
VTI - the highlights
First, let me start with a brief introduction to the fund itself. I won't cover the basics that you can easily find on the fund's webpage. Instead, I will anchor the introduction with a comparison of three ETFs and highlight the differences. These three funds are Vanguard S&P 500 ETF (VOO), Vanguard Mid-Cap Index Fund ETF Shares (VO), and Vanguard Russell 2000 Index Fund ETF Shares (VTWO). As seen, VTI enjoys the largest AUM (a whopping $1.55 trillion) and a rock-bottom fee of 0.03%.
In terms of fundamentals, these four funds track, respectively, the entire US stock market (including large, mid, and small-cap companies across all sectors), the S&P 500 index (the large caps), the CRSP US Mid Cap Index (the mid-caps), and the Russell 2000 Index (the small caps). Next, I will explain the advantages that VTI can offer thanks to such diversified exposure.
Lower valuation risks
Before I dive into the specifics, l will first provide an overview of the valuation method that I use in this article. Besides the use of usual metrics like P/E ratios, the other main method that I will use is the dividend yield. For a diversified ETF (like any of the four mentioned above), dividends offer a good approximation of owners' earnings in the long term. The reason is that they represent the portion of the dispensable cash flow that can be distributed to shareholders by the underlying companies. However, there are limitations to this approach and a complete understanding would also need to consider other factors which I will detail at the end of the article.
With this background, the next chart shows my calculation of VTI's dividend yield in comparison to other market segments. As seen, VTI's current dividend yield is 1.36% and its 4-year average dividend yield is 1.49%. As such, VTI's current dividend yield is lower than its 4-year historical average, indicating that VTI is currently overvalued relative to its historical dividend yield.
However, overvaluation is not uniformly distributed among the market segments. And my view is that the overvaluation risks are concentrated in the large caps. As seen in the chart below, the valuation of large caps (i.e., the S&P 500 index) currently sits at 35.2x in terms of the Shiller CAPE ratio. It is the third highest level since the 1880s, only after the dot.com bubble and the epic easing after the COVID-19 pandemic. While in contrast, mid-caps and small caps are trading at their historical valuation (or even at a slightly discounted valuation) as indicated by the higher yield from VO and VTWO compared to their historical averages.
Growth prospects
To make VTI more attractive, the mid-caps and small caps also provide the potential for faster profit growth. The next chart shows the dividend growth rate (in CAGR terms) for VTI, VOO, VO, and VTWO over the past 3~5 years. As seen, VTI's 3-year CAGR has been 7.75% and its 5-year CAGR is 4.71%. Both are faster than VOO's growth rate (5.98% and 4.65%, respectively, for the past 3 and 5 years). And the drivers for VTI's faster growth are precisely the mid- and small-caps. To wit, the mid-caps (approximated by VO) enjoyed a 3-year CAGR of 9.04% and a 5-year CAGR of 8.26%. The small-caps (approximated by VTWO) have grown at even faster rates with a 3-year CAGR of 11.31% and a 5-year CAGR of 8.44%.
I don't think these historical data are a one-time coincidence and anticipate the trend to persist in the future. To start, the above data represent a multiple-year track record already. Second and more fundamentally, mid-cap companies are in a growth stage and have more opportunities to reinvest their earnings compared to mature large caps. Small-cap companies are even earlier in their growth cycle and usually prioritize aggressive reinvestment for rapid expansion.
Risks, and final thoughts
In the end, all market segments are highly correlated. As a result, all funds mentioned above are subject to the common set of risks (macroeconomics, inflation, interest rates, etc.) I won't further detail these risks as there have been many other excellent articles on the SA platform along these lines. Here I will point out a limitation that is specific to my analysis method used. The limitation is detailed in Our earlier article. A recap is provided below and the essence is that dividends do not perfectly reflect owners 'earnings:
Dividend yields do not always reflect business fundamentals due to several factors such as tax law, political climate, the composition of the market index, et al. As a result, we do not directly use the yield spread in our investment or asset allocation decisions. In practice, we first adjust for the above corrections and then use the adjusted yield spread in our investment decision. But the data and approach illustrated here is the first place we check.
To conclude, our overall view is that there is too much risk, and growth expectations are baked into large caps (like those held in the S&P 500 index). As such, we prefer the use of a total market fund like VTI over the use of S&P 500 funds like VOO. The inclusion of mid and small-cap companies can provide exposure to higher growth potential at a much more reasonable valuation (even slightly discounted compared to the average in the past few years) compared to the S&P 500 index.
Finally, we certainly put our money where our mouth is. VTI is a core holding in our own account as shown in the chart below. We follow a barbell investing model (detailed in our blog article). Rather than holding a bunch of assets with medium risks, we like holding an aggressive growth portfolio (with assets like TQQQ and XBI) and a very conservative portfolio (like cash and some of our defensive tactical positions). In our growth portfolio, we are currently allocating more than 17% of our total assets to VTI.
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