It has been a busy few weeks in the Henry household since my last post in March. I will get into more detail here soon, but today I wanted to discuss index fund investing again. Specifically, I thought I would take a deeper dive into one index fund, the Vanguard Total Stock Market Index (VTSAX), that is a favorite of the FI and FIRE communities as well as myself. VTSAX is one of the largest mutual funds in the world, and there is good reason why.
What is VTSAX?
The Vanguard Total Stock Market Index (VTSAX) is a stock index mutual fund created and managed by Vanguard. If you recall from a previous post, Vanguard was founded by John Bogle who is considered by many to be the father of index fund investing.
VTSAX was created in 1992 and is widely considered a principal index fund in the FI and FIRE movement as I noted above. You’ll recall from my previous post, an index fund is a type of mutual fund or exchange-traded-fund (ETF) that seeks to track an underlying index. In doing so, the fund seeks to match the performance (i.e. return) of the index the fund seeks to track. For this reason, the intent of an index fund is not to “BEAT the market” but instead to “BE the market”. Index funds historically allow the average investor to achieve higher returns but at lower costs than actively managed investment alternatives.
Since VTSAX is a stock index fund, it too is designed to track an underlying index. In this case, the index being tracked is the CRSP U.S. Total Market Index. In tracking this index, VTSAX is designed to provide investors with exposure to the entire US stock market to include small, medium, and large companies. For this reason, VTSAX at its core is a fund that seeks to invest in virtually all investible stocks in the US with the intent to track the performance of the broad US equities market. This diversification is central to what makes VTSAX so attractive to investors to include those in the pursuit of financial independence.
What is in VTSAX?
As of 03/31/2021, VTSAX had 3,755 individual stocks comprising the fund for $1.2 trillion in net assets. [1] The chart below shows you the various sectors represented within the fund as of the same time period.
As you can see, the technology sector represents over 25% of the entire fund. Think large technology companies like Apple, Microsoft, Amazon, Google, Facebook, etc. This is where you may ask yourself why technology companies represent such a large portion of the fund if it is intended to represent the entire US stock market? The answer is quite simple. Like many index funds, VTSAX is “market-weighted” or “cap-weighted”. Let me explain further.
Understanding Market Capitalization:
Stocks are often classified by the size of the corresponding corporation. The most common way for classifying a stock by size is to look at the market capitalization (cap for short) which refers to how much a company is worth as determined by the stock market.
More specifically, the market capitalization of a company represents the total market value of all outstanding stock shares. In order to calculate a companies market capitalization, you simply multiple the stock’s current share price by the number of stock shares outstanding.
- Market Capitalization = Stock Share Price x Number of Shares
For example, if a company trades at $100 per share and there are 1 million shares outstanding, the company’s market capitalization would be $100 million ($100 per share x 1 million shares).
Market capitalization can be an easy method for estimating a companies value in real-time. However, it is important to understand that market capitalization may not always be an accurate indicator of a companies true value since stock share price is ultimately driven by supply and demand in the market. As a result, shares may be under-valued or over-valued by the market at any given time.
Using Market Capitalization to Bucket Stocks:
Since market cap is often utilized to stratify companies by size, there needs to be an underlying, generally accepted way to compare companies of varying sizes. You may see slightly different ranges depending upon the institution or source you reference, but generally stocks are placed into the following buckets/ranges:
- Large Cap Stocks – Market Cap Over $10 Billion
- Mid Cap Stocks – Market Cap Between $2 Billion and $10 Billion
- Small Cap Stocks – Market Cap Between $300 Million and $2 Billion
- Micro Cap Stocks – Market Cap Between $50 Million and $300 Million
Since VTSAX represents the broad US stock market, it invests in companies across the market capitalization spectrum. In future posts, we can do a deeper dive into characteristics of each category noting in general large cap stocks are considered less risky (think large, established companies in established industries) while small and micro cap stocks are considered higher-risk investments.
VTSAX Top 10 Holdings:
Since VTSAX is market weighted, large companies like Apple, Microsoft, and Amazon are going to have a larger individual market cap. As of 03/31/2021, the top 10 largest holdings (seen below) represented ~ 22% of the overall assets within the fund. [1]
- Apple
- Microsoft
- Amazon
- Alphabet (Parent Company of Google)
- Tesla
- Berkshire Hathaway (Warren Buffet’s Investment Firm)
- JPMorgan Chase
- Johnson and Johnson
- Visa
I am sure you will recognize most if not all of the companies above. Since these companies are the 10 largest holdings, they have the largest market caps. This typically is indicative of a company that has been around for some time and/or they are key players in an established industry. For reference, the chart below shows each company with their corresponding number of shares and total market value for you number nerds out there like me.
| Holdings | Shares | Market value |
| Apple Inc. | 425,736,681 | $52,003,735,584 |
| Microsoft Corp. | 212,513,228 | $50,104,243,766 |
| Amazon.com Inc. | 12,060,439 | $37,315,963,101 |
| Facebook Inc. Class A | 67,777,292 | $19,962,445,813 |
| Alphabet Inc. Class A | 8,470,239 | $17,470,037,342 |
| Alphabet Inc. Class C | 7,848,441 | $16,235,520,506 |
| Tesla Inc. | 21,636,063 | $14,451,375,560 |
| JPMorgan Chase & Co. | 85,976,851 | $13,088,256,028 |
| Berkshire Hathaway Inc. Class B | 50,300,191 | $12,850,189,795 |
| Johnson & Johnson | 74,068,436 | $12,173,147,457 |
| Visa Inc. Class A | 47,562,661 | $10,070,442,214 |
For those interested, you can view all holdings within VTSAX on Vanguards website above.
VTSAX Fees:
VTSAX currently has an expense ratio of .04%. If you recall from previous posts, the expense ratio represents how much of a fund’s assets are used for administrative and operating expenses. Vanguard was built upon a low cost business model. An expense ratio of .04% is not free but it is pretty close to it. For reference, according to Vanguard’s website, the average expense ratio of similar funds is .83%. [2]
As we covered in my previous post, costs are important because (1) they are in your control and (2) they can eat away at your wealth without you even realizing it. A difference of .79% (.83% less .04%) may not seem like a lot, but I assure you that it is. Let’s look at an example.
Let’s assume a starting investment of $10,000. You invest $1,000 each month for 30 years. Let’s assume an 8% return net of fees. After 30 years and $370,000 in total contributions, you would have $1,460,025.
Now let’s reduce your 8% return by .79% (.83% less .04%) to account for the additional fees you would pay if you invested in a similar fund with an average expense ratio. The resulting net rate of return would be 7.21%. Assuming the same $10,000 starting investment, $1,000 monthly contribution, and 30 year timeline, you would have $1,258,006.
That is a difference of $202,019 over 30 years. Larger starting balances and/or larger monthly contributions will result in larger fees and subsequently a larger loss of your wealth over time. This is why it is important to always keep in mind costs even if they seem small on the surface because they can significantly impact your ability to grow and preserve your wealth.
VTSAX Performance:
The screenshot below outlining average annual returns for VTSAX was pulled directly from Vanguard’s website.
There are several things to point out about performance over the last ten years and since inception.
- The one year return (62.73%) is very misleading. Since this return is calculated based upon a rolling one year time period, the outsized return is being driven by the market decline in early 2020 driven by the COVID-19 Pandemic and the subsequent recovery we have experienced within the last year or so. Outsized returns like this are being seen in most mutual funds so VTSAX is not alone. This will eventually level out as the months continue to pass.
- The ten year return (13.79%) is not necessarily misleading. However, it is very important to remember that we have been in a bull market for 10+ years now. Sure, the bull market technically ended in March 2020, but the recovery was extremely quick, and now we are at all time high again. For this reason, I like many others, consider the current bull market as simply an extension of the pre-COVID-19 bull market. You cannot and should not expect a return of 13%+ for your investing lifetime as this is not likely.
- The performance since inception (8.05%) is closer to what you could reasonably expect in the long-term. Again, it is very important to point at that no one can predict the future, and historic performance does not dictate future performance. However, the stock market has always gone up over the long-term since it is ultimately tied to the US economy which historically has continued to innovate and grow. This may not always be the case because the past does not guarantee the future, and it is important to understand and recognize this.
As far as a real-world performance example, it is always fun to see what an investment would have done over the long-term. I frequently utilize PortfolioVisualizer to backtest a portfolio allocation or asset class. This is a great tool to check out if you have not checked it out before.
Utilizing this tool, I ran a hypothetical $10,000 investment in 1972 invested 100% in the US Stock Market. What do you think this investment would be worth in 2021 assuming no additional contributions?
The answer is $1,512,975!
This represents a compound annual growth rate (CAGR) of 10.73%. Adjusted for inflation, the CAGR was 6.63%. Not too bad… I included a couple of charts from Portfolio Visualizer below for visual reference.
Everyone likes the portfolio growth chart because it shows the long-term growth of the hypothetical $10,000 investment. However, the second chart is just as important because it shows annual returns during the same time period. It is here that you will see years with significant declines including 1973 – 1974, 2000 – 2002, and 2008 with the worst year being in 2008 (-37.04%). These years seem insignificant when looking at them through the lens of the entire time period. However, at the time and in the moment, I assure you the years with a significant decline are not insignificant.
VTSAX Alternatives:
VTSAX is not the only index fund designed to track the total US stock market. There are numerous alternatives offered by Fidelity, Schwab, and others. In addition to mutual funds, there are also exchange traded funds (ETFs) designed to track the total US stock market as well. VTI is the Vanguard Total Stock Market ETF equivalent of VTSAX. The expense ratio is slightly lower at .03%, but the holdings and underlying goal of the fund are the same. I won’t get into too much detail here, but it is important to point out there are alternatives in the market.
Advantages of VTSAX:
VTSAX has many advantages that drive investors to choose this fund as a core component of their portfolio to include their taxable investments. Here are a few:
- Diversification: VTSAX offers equity diversification since it tracks the broad US stock market. As noted above, there are over 3,700 companies represented in the current index.
- Simplicity: VTSAX offers a one-stop-shop for US equities. You don’t have to worry about buying multiple funds to represent large, mid, small, and micro cap companies. You also don’t have to worry about picking “the right stocks” to invest in.
- Cost: As noted above, the costs associated with VTSAX are very low compared to other alternatives in the market. There are lower cost alternatives in the market, but when comparing .04% to something lower, the difference is largely inconsequential.
- Tax Efficiency: While we didn’t explicitly cover this already, VTSAX is known to be very tax efficient due to not only the nature of the index it follows, but also the management of the fund, low portfolio turn-over, etc. For long-term buy-and-hold investors, tax efficiency is key and VTSAX delivers.
In addition to the somewhat obvious advantages above, there is one advantage that is important to highlight that may not be so obvious.
Index funds designed to track the overall US stock market, to include VTSAX, are self-cleansing. JL Collins highlights this concept very well in his book the Simple Path to Wealth. A lot of people are intimidated by investing, because they associate investing with gambling because it requires you to pick winners and losers. In reality, you don’t have to. In fact, you shouldn’t even try because it is a loser’s game. Let’s play a little game.
Can you name the 10 largest companies in the US in 1980?
I know I couldn’t. I had to look it up. Here they are.
- Exxon Mobil
- General Motors
- Mobil
- Ford Motor
- Texaco
- Chevron Texaco
- Gulf Oil
- International Business Machines
- General Electric
- Amoco
Source: https://archive.fortune.com/magazines/fortune/fortune500_archive/full/1980/
Notice a pattern? The largest companies in 1980 represented the largest sectors in the US economy at the time including energy and automotive. Technology companies were not a thing in 1980. That is not the case anymore. This is the beauty of owning an index fund designed to represent the broader market. You don’t have anticipate or predict upcoming innovations or new industries or pick winners and losers. You don’t even have to pick an investment manager that you hire to pick winners and losers.
Since VTSAX represents the broad US stock market, the fund is continually evolving as the market evolves. Many companies will continue to grow and their market cap will subsequently increase as time passes. Other companies will begin to decline and their market cap will subsequently decrease as time passes. VTSAX will constantly adjust to account for these changes. By investing in VTSAX, you are investing in a low cost, broadly diversified, self-cleansing fund that invests in American innovation and growth.
Disadvantages of VTSAX:
Although VTSAX has many advantages, there are also several potential disadvantages that should be acknowledged. Here are a few:
- There is no exposure to less risky financial instruments to include bonds. Investments such as bonds serve to reduce risk in a portfolio since they do not necessarily behave the same as stocks/equities. This is why it is important to understand your risk, different types of investments, and choose an asset allocation that is right for you.
- There is no exposure to international equities. Many would argue that investing in VTSAX is indirectly investing in international markets since many of the largest US companies conduct a significant portion of their business internationally. This is true to some extent, but it is still important to point out you do not have direct exposure to true international companies. This again is why it is important to choose an asset allocation that is right for you and that will often include some level of exposure to international equities as well.
- Despite the diversification offered by the US market, the fund in itself still presents market risk as with investing in any other stock. You can see this in the historical declines noted in the previous visual above. Although, the fund has gone up in the long-term, historical returns do not equate to future returns and there were years with a significant loss. Investing in stocks is not a risk free endeavor, and this is important to understand.
- Performance will be dictated by the overall market as a whole and not individual companies. This helps to mitigate the risk associated with companies that lose value over time. However, it also blunts the potential growth associated with individual companies that may experience outsized growth over any given time period. This is where proponents of individual stock investing come into play. This requires picking winners and losers which can be very difficult in the short term and almost impossible in the long term.
Many of the disadvantages above can be eliminated or mitigated in the ways noted. The main take-away is to understand there are pros and cons to any investment. Educate yourself and make the decision that is right for you.
Take-Away
VTSAX can serve as an excellent investment by itself or as a part of a larger investment portfolio. Many people, including myself, use VTSAX as a core position within a taxable portfolio due to the advantages previously noted. As with any investment, you should do your own due diligence before making a decision on where to invest. As you continue your journey to FI, you will likely hear the phrase “VTSAX and Chill” at some point. Hopefully today’s post provided some additional insight as to why.
Regards,
Henry
Note: The information published in this post is for informational and entertainment purposes only, and does not constitute accounting, tax, investing, or other professional advice. All examples provided were for entertainment and illustrative purposes only. Readers should not take action on any information within this post. Readers should instead seek advice from a tax professional.
References:
[1] https://investor.vanguard.com/mutual-funds/profile/vtsax
[2] https://investor.vanguard.com/mutual-funds/profile/fees/vtsax
*** All photos credited to Unsplash.com