Should You Invest in a Broad Market Index?
What does it mean when you hear advice about investing in a broad market index? Should you invest in broad market index funds?
Index funds have gained in popularity in recent years and have become the preferred choice in the general investment community. In fact, a broad market index fund, Vanguard Total Stock Market Index (VTSMX) is the biggest mutual fund in the world, as measured by assets under management.
Broad market index funds have definite advantages for investors but they're not always used properly. Here's what to know about broad market index funds before you invest:
What Are Broad Market Index Funds?
Just as it the term sounds, broad market index funds invest in a large segment of the investable market, often targeting certain securities, such as stocks or bonds. Those that offer the broadest market exposure to investors are often called total market index funds.
For example, a mutual fund or Exchange Traded Fund (ETF) that tracks the S&P 500 Index is a broadly diversified index fund but most often the broad market index term refers to a fund with broader exposure than that -- a fund that would invest in a broader index, such as the Wilshire 5000 or Russell 3000. The holdings in the Wilshire 5000 and Russell 3000 include most of the domestic U.S. stock holdings traded on stock exchanges, which is why the "total market" name is usually included in the fund name.
Broad market index funds that invest in bonds often track the Barclay's US Aggregate Bond Index, which consists of approximately 17,000 bonds, hence the name "total bond index" for those index funds that track it.
Advantages of Broad Market Index Funds
Broad market index funds have the same advantages that every index fund offers and then some. Here are the primary advantages for investors:
- Low expenses: Like most other index funds, broad market index funds often have expense ratios lower than 0.20 percent, which is just $20 for every $10,000 invested. Low expenses help boost returns, especially in the long run, because fewer fees equal more money invested to grow and compound over time.
- Low Turnover: A primary reason for the low expenses of index funds is that the holdings are not sold and replace at a high rate. This security replacement is called turnover, which can be described as the percentage of the fund’s holdings that were replaced with a different investment (or “turned over”) during the previous year. Many funds that are actively-managed (non-index funds) can have turnover higher than 50 percent, whereas index funds usually have turnover lower than 5 percent.
- Tax-efficiency: A direct result of low turnover is a reduction in taxes passed through to the investor. When mutual funds sell holdings at a price higher than the purchase price, it produces a capital gains tax, which is then passed along to investors in the form of “capital gains distributions.” If you hold a stock fund in a taxable account, you’ll pay taxes on these distributions. Therefore, assuming you like to minimize taxes, you’ll want a tax-efficient fund, such as a broad market index fund.
- Broader Diversification: Most index funds are diversified, meaning that they invest in a large number of securities. However, broad market index funds offer greater diversity, meaning that they invest in a large number of securities than the average index fund. For example, many total stock market index funds invest in more than 3,000 stocks, whereas an S&P 500 index fund invests in approximately 500 stocks.
- Passive Management: Like other index funds, broad market index funds are passively managed, meaning that the manager is not actively trying to beat the benchmark index; instead they are attempting to track the performance of the benchmark. This is an advantage because it removes the risk that the manager will make poor decisions, usually based upon human emotions, such as greed and fear, that can impair judgment. In different words, index funds remove manager risk from the investment.
- Tax-Efficiency: A direct result of low turnover is a reduction in taxes passed through to the investor. When mutual funds sell holdings at a price higher than the purchase price, it produces a capital gains tax, which is then passed along to investors in the form of “capital gains distributions.” If you hold a stock fund in a taxable account, you’ll pay taxes on these distributions. Therefore, assuming you like to minimize taxes, you’ll want a tax-efficient fund like VTSMX.
Put simply, broad market index funds have the same advantages of other index funds, but the diversification advantage is greater.
Total Stock Market Index vs S&P 500 Index
A good way to determine if broad market index funds are a smart investment choice for you is to look at the differences between total stock market index funds vs S&P 500 index funds.
Total stock market funds typically track the performance of the Wilshire 5000 Index of the Russell 3000 Index. These broad market indices cover the full range of capitalization, which includes large-cap stocks, mid-cap stocks, and small-cap stocks. However, an S&P 500 index fund will only include the large-cap stocks and possibly some mid-cap stocks. This makes total stock market index funds more diversified than S&P 500 index funds.
One important aspect of the total stock market index funds to keep in mind is that they usually track a "cap-weighted" index, which means that the higher the market cap, the greater the "weight", or exposure, to the stock in the index. Therefore, a total stock market index fund can be heavily weighted toward large-cap stocks, making the performance similar to an S&P 500 index fund.
With that said, investors can expect long-term performance to be slightly higher with a total stock market index fund because even a small amount of mid- and small-cap stocks can help boost performance (based upon historical averages that would predict smaller capitalization performs better than large-caps.
A Few Cautions With Using Broad Market Index Funds
Again, using a total stock market index fund as an example, investors should keep in mind that the exposure to mid- and small-cap stocks, in addition to large-cap stocks can cause fund overlap in a portfolio if the investor decides to hold mid- and small-cap funds.
For example, if an investor wanted to maintain a 20 percent portfolio allocation to small-cap stocks, they would need to be aware that their total stock market index fund already holds small-cap stocks and adjust their small-cap fund allocation accordingly.
Also, although broad market index funds are well-diversified, they may not be sufficiently diversified to meet the needs of most investors, who need a mix of assets (i.e. stocks, bonds, and cash), as well as diverse regional exposure (i.e. U.S. and international stocks).
If used properly, broad market index funds can be a smart investment tool for almost any investor.