The backbone of any three-fund portfolio is a U.S. stock market index fund. The two most common stock funds are the S&P 500 and the Total Stock Market index fund. These are both excellent choices, but at some point, you need to pick one or the other. So which one should you choose?
Let’s look at the tale of the tape between these two indices, using the Vanguard ETF for the S&P 500 (VOO) and the Total Stock Market (VTI) as proxies:
|S&P 500 (VOO)||Total Stock Market (VTI)|
|Approx. Market Cap||$22 trillion||$27 trillion|
|Number of Stocks||505||3591|
|% Large-Cap Stocks||100%||73%|
[Data: Morningstar, World Bank, Standard & Poors]
And here are the recent historical returns of the S&P 500 and Total Stock Market index:
|Returns||S&P 500 (index)||Total Stock Market (VTI)|
The correlation in returns between the S&P 500 and the Total Stock Market Index is very, very high. Using this correlation calculator by BuyUpside, the correlation between VTI (Vanguard’s Total Stock Market ETF), and VOO (Vanguard’s S&P 500 ETF) is 99.96%. This is because approximately 75% of the total stock market portfolio is the S&P 500, and U.S. small cap stocks have a high correlation with U.S. large-cap stocks.
For comparison, the correlation between VTI and EFA (an International Developed Stock Markets ETF) was 83.4%, and the correlation between VTI and AGG (a total bond index ETF) was 83.4%. The diversification benefits of the Total Stock Market index over the S&P 500 are relatively limited.
Reasons to Invest in the S&P 500
The S&P 500 is the “gold standard”
Even experienced, well-educated index fund investors will often try to compare their portfolios to the S&P 500. The competitive nature of investors comes out even in the index fund world, where even though you’re trying to be average, some people try to seek a “better average” than the S&P 500. When you invest in the S&P 500, the temptation to compete against a benchmark index is eliminated.
If you want small-cap exposure, you can invest directly into a small-cap ETF
Some investors like to overweight (tilt) their portfolios towards small cap stocks. By investing in the S&P 500, you can more cleanly tailor your large-cap and small-cap exposures to your liking. If you invest in the total stock market, then you need to account for the fact that the total stock market is approximately 73% large caps, 18% mid-caps, and 9% small-caps.
Investment aggregator services such as Personal Capital can help you sort out your large-cap and small-cap exposures, but owning specific large-cap and small-cap index funds simplifies this process.
Reasons to Invest in the Total Stock Market
Diversification: Mid-cap and small-cap exposure in a single investment
Investing in the total stock market allows you to get mid-cap and small-cap exposure, in proportions equivalent to that of the U.S. stock market, in a single investment. Many investors, including myself, have no desire to tilt our portfolios towards small-cap stocks.
(Potentially) slightly higher returns, with slightly more risk
In the past 15 years, the total stock market has had slightly higher long-term returns because of its mid-cap and small-cap components. However, very long-run returns of the S&P 500 and Total Stock market (1928-2010) have shown the S&P 500 to have slightly higher returns than the total stock market (10.4% vs. 10.2%), as noted by Jack Bogle in this article. So no one really knows whether the S&P 500 or Total Stock Market will have better returns in the next 30 years.
Avoiding the “Google” effect
Columnist Allan Roth also notes a potential advantage of the total stock market that he terms the “Google effect.” Typically, changes in the composition of the S&P 500 are made after-hours. When these changes happen, companies that are added to the S&P 500 rise and companies that are subtracted fall.
For example, Google rose 7.3% in after-hours on the evening it was announced that they would be added to the S&P 500. In this case, total stock market index holders benefited from this rise, while S&P 500 index funds had to buy Google at inflated prices.
The turnover of the S&P 500 is relatively infrequent, so the erosion in returns because of this phenomenon is relatively small.
If I had a choice between Total Stock Market or S&P 500, I would pick the total stock market because of its diversification benefit. My wife, on the other hand, uses the S&P 500 for her investment accounts, preferring the familiarity of this index.
However, if you do not have the opportunity to purchase the total stock market in your investment account, then investing in the S&P 500 is an excellent alternative. This is the case for me, where my 403(b) and HSA do not offer total stock market index funds as investment options. I invest in the S&P 500 in these accounts with no hesitation. I do not attempt to replicate the total stock market by purchasing mid-cap or small-cap funds in other accounts.
Remember, for Fidelity and Schwab account holders, you should use the ETF versions of these index funds within taxable accounts because of the favorable tax treatment of ETFs. In tax-deferred accounts, you can use either ETFs or mutual funds. Vanguard account holders can use either the ETF or mutual fund version in any account.
How do you invest in the U.S. stock market? Do you use the S&P 500, Total Stock Market, or neither?