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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.