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IF YOU WORKED AT Vanguard Group, you felt like a kid in a candy store when it came to picking investments. There were so many well-run, low-cost funds to try. Yet my favorite fund wasn’t offered as an investment option in the Vanguard 401(k) plan. Ironically, it’s the fund that made Vanguard’s reputation.
Vanguard opened its S&P 500 index fund (symbol: VFIAX) in 1976. This first commercially offered index fund was designed to earn the U.S. stock market’s average return by owning every stock in the S&P 500 in proportion to its market value. The fund slowly rose to dominance as its returns dependably exceeded the majority of actively run funds, decade after decade.
For me, the fund was a sentimental favorite. I began investing in Vanguard’s S&P 500 index fund through my IRA when I was an associate editor at Kiplinger’s Personal Finance magazine. I appreciated its low cost and persistently good returns. It was also my favorite recommendation to readers.
In the course of my reporting, I interviewed many fund managers. While they were often bright and personable, I noticed that even those managers with the most compelling stories tended to lag behind the S&P 500, often badly. I began to appreciate the genius of the index fund. Though I couldn’t guess where the greatest returns from the market would emerge next, I’d profit from the wave anyway if I just held onto the index.
Yet the 500 fund’s success wasn’t enough for Vanguard’s founder, Jack Bogle. In his memoir, Bogle reported walking into the office of the fund’s manager, Gus Sauter, in 1992 and saying, “Gus, let’s stop messing around and let’s do a total stock market fund.” Bogle wanted an index fund based on the broadest possible measure of the U.S. stock market, then the Wilshire 5000.
This became Vanguard’s total stock market fund (VTSAX), which today owns more than 3,600 stocks in its portfolio. It’s this fund—and not the 500 fund—that’s offered in Vanguard’s 401(k) plan. The fund includes the small and mid-cap stocks that the S&P 500 fund excludes.
The total stock market is arguably the better fund because it’s more broadly diversified. About 20% of the fund’s portfolio is invested in small-cap stocks, whose returns were long reputed to beat large-cap stocks over time.
It just hasn’t worked out that way lately. As of July 31, the S&P 500 fund has a 13.11% average annual return over the past 10 years, compared to 12.52% for the total stock market fund. The 500 fund has beaten the total market fund’s returns over one, three and five years as well.
Why, contrary to expectations, is the S&P 500 fund outperforming the total market fund? I can think of five reasons:
1. Higher dividends. The S&P 500 has more invested in big dividend payers. The S&P 500 fund yielded 1.25% as of July 31, just a whisker more than the total stock market fund’s 1.24%. It’s a slight edge, yet it seems persistent.
Dividends deserve great respect because they represent dollars returned to investors. By contrast, stock price appreciation is only realized at redemption and is never as certain.
2. Active selection. The 500 fund is unmanaged, buying the stocks in the S&P 500 index. The index’s lineup is supervised, however, by a committee at S&P Dow Jones Indices that does make periodic changes. The committee’s mandate is to select the leading companies in leading industries whose shares are traded on U.S. stock exchanges.
The committee gave the hook to sports apparel firm Under Armour in 2022 after its share price had fallen by more than half. To take its place, it added beverage maker Keurig Dr Pepper whose single-brew coffee service began showing up everywhere I went.
This regular housecleaning tends to show faltering firms the door, while welcoming rising stars to the large-cap club. The index minders are, in effect, selling losers and holding onto their winners, a well-regarded investment strategy. The total stock index fund has no similar oversight.
3. Speculation. When a company is added to the 500 club, its shares experience an overnight price jump. That’s because all S&P 500 funds must buy shares to add to their portfolio.
Vanguard’s longtime index chief, Gus Sauter, bought futures in the handful of stocks most likely to be added ahead of the committee’s announcements. As a group, these stocks tended to represent profitable companies whose market cap had just reached the bottom rung of the 500.
Through this and other profitable maneuvers, Sauter managed to earn enough to run the fund at a minuscule annual cost, currently 0.04% of assets, or four cents a year for every $100 invested. Sauter is so highly regarded at Vanguard that they’ve named a road on the company’s Malvern, Pennsylvania, campus after him.
4. Large-cap dominance. Large-cap stock returns have been beating small-cap stock returns for years, just the reverse of what was observed in the 1970s and 1980s. There appear to be some inherent advantages to large size.
For example, large-cap companies often use their strong balance sheets to buy back billions of dollars’ worth of their stock. As the share float shrinks, earnings per share will rise as long as profits stay constant. That helps support the stock price, as well as the CEO’s compensation, which is so often set to reflect shareholder performance.
Lately, the largest tech companies have achieved global dominance and expanded into booming new fields, such as cloud storage and artificial intelligence. Information technology firms have lately come to represent nearly a third of the S&P 500 index’s total value.
5. Luck. The worrier in me can’t ignore the possibility that the S&P 500’s outperformance is due to random chance or, worse yet, a bubble in the tech sector. If that’s the case, the 500 fund’s returns may revert when tech corrects, as it has before, often painfully.
I hope I haven’t jinxed my favorite fund by writing this article. I will continue to own it through my IRAs, although my larger holding is the better diversified total stock index fund, which I continue to own through the Vanguard 401(k). I guess I’m covered whichever one comes out ahead.
Greg Spears is HumbleDollar’s deputy editor. Earlier in his career, he worked as a reporter for the Knight Ridder Washington Bureau and Kiplinger’s Personal Finance magazine. After leaving journalism, Greg spent 23 years as a senior editor at Vanguard Group on the 401(k) side, where he implored people to save more for retirement. He currently teaches behavioral economics at St. Joseph’s University in Philadelphia as an adjunct professor. The subject helps shed light on why so many Americans save less than they might. Greg is also a Certified Financial Planner certificate holder. Check out his earlier articles.
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The fact that Vanguards S&P 500 fund is so heavily weighted in tech stocks concerns me. What do you think of the equally weighted Vanguard index funds?
Thank’s for the helpful review. Another aspect of this is that these funds can be pieced together for tax loss harvesting for taxable investments. The total US fund can be matched with the S&P 500 and the extended market fund to collect tax losses during downturns without leaving the market. I signed up for Vanguard’s automatic tax harvesting program—someday the market will duck and this will get used.
A financial advisor and accountant should review individual situations to see if this is appropriate. Vanguard analysts summarize that this is most worthwhile if you invest the tax savings.
My apologies in advance to any of your readers who might be offended by this comment, but the difference in 10 year returns between the S&P 500 and Vanguard Total Stock Market fund strikes me as being no more than the difference between “happy” and “glad.”
Yes, there are reasons for the differences in returns, but for most investors, achieving 10 year returns of either 13.11% or 12.52% would be cause for celebration, not remorse.
In my experience, why these sorts of returns are rare for investors can often be attributed to: over confidence in asset selection, impatience when holding an investment, ignoring fees, market timing and bad asset allocation.
For most investors, buying and holding a broad based equity fund (or balanced fund) with low fees would be a winner, but few investors seem to have the patience or discipline necessary for such a strategy.
I own VFIAX, VEXAX and VTIAX in my IRA. But VTSAX in my very small Roth and VTSAX and VTIAX in taxable. I have been thinking of combining VFIAX and VEXAX into VTSAX but maybe I should just leave them alone… I have less in VEXAX, but not a whole lot less.
I think it would depend on your reasons for combining the SP500 and Extended Market funds in your IRA and in what percentages.
Some people do around an 80% SP500 and 20% Extended Market to emulate total market performance when they don’t have access to a total market fund.
If you’re around these percentages and have access to a total market fund, I would just exchange into the total market. If you are over or underweighting those percentages for other reasons, then you may want to leave all alone.
Why on earth did this get down voted? Please explain your reasoning.
I didn’t down vote your comment. But I suspect a reader didn’t like that you referred to funds solely by their ticker symbols. A lot of folks won’t know which funds those initials refer to. Other commenters also refer to funds solely by their ticker symbols — and I wish they’d stop.
Good point. I was short on time.
You can go in and edit your post when you have the time to rectify what is in Jonathan’s post. Just click on the time stamp next to your name, the click on the gear like symbol.
I’m not sure people know this. I have learned this as for some reason this site refreshes every couple of minutes on my IPad so I have to save and copy what I have written the edit multiple times otherwise my current writing is wiped out.
PS you have to wait about 30 seconds after you post before you click on the time stamp.
We also own both SP500 and Total Market. We own Total Market everywhere we have a choice (IRAs, Taxable, Solo 401k) and SP500 in the 401k offered by my employer where Total Market isn’t an option.
Since the SP500 makes up such a large percentage of the Total Market – not by number of companies, but by market capitalization – I don’t give much thought to the two or which one’s better than the other. The performance should always be pretty close long term and I’m betting the slight lead will change back and forth over time.
Good article though, it’s interesting to think about.
I own the S&P 500 in a taxable account, but most of my U.S. stocks are in either
in Vanguard’s total market choice or the world fund. You give good reasons for the better performance of the S&P fund over a decade and more, but don’t you think broader diversification will win over time?
Yes, I think diversification does win in the long run. It reduces risk and concentration in the largest U.S. tech stocks, which have so dominated market returns lately.
Greg, Have owned and loved the VFIAX mutual fund for decades. In recent years, we have used and prefer Vanguard’s ETF version of the S&P 500 – VOO for new monies. The ETF enables an instant purchase versus the mutual fund executing at close of business.
We have forever been mostly S&P 500 folks, originally because it was a main 401k option. The S&P adds winners and ejects losers as you nicely point out. After retiring, we did shift into tech index funds in addition to our S&P holdings, but we have never owned any total market or international fund.