Market-cap-weighted indexes' greatest strength is arguably also their biggest weakness.
By Adam McCullough, CFA | 08-05-17 | 10:03 PM | Email Article

The following is our latest Fund Analyst Report for Vanguard 500 Index Fund . Morningstar Premium Members have access to full analyst reports such as this for more than 1,000 of the largest and best mutual funds. Not a Premium Member? Gain full access to our analyst reports and advanced tools immediately when you try Morningstar Premium free for 14 days.

Adam McCullough, CFA, is an analyst on Morningstar’s manager research team, covering passive strategies.

Vanguard 500 Index offers broadly representative and well-diversified exposure to U.S. large-cap stocks. This fund’s fee and a soundly constructed and reasonably representative portfolio leave it well-positioned to continue its long streak of generating attractive risk-adjusted returns relative to its peers over the long haul. It earns a Morningstar Analyst Rating of Gold.

Broad diversification is an intrinsic advantage of fund’s replication of the market-cap-weighted S&P 500, which covers approximately 80% of the investable U.S. stock market. An index committee manages the S&P 500’s composition, while most indexes follow mechanical, rules-based approaches. Yet, this index has performed similarly to other popular large-cap indexes, such as the Russell 1000 Index. Market-cap weighting pulls the portfolio toward the largest U.S. stocks and accurately reflects the composition of the market. Its market-cap-weighting approach can be beneficial in bull markets that are characterized by large-cap leadership, such as the post-financial-crisis charge in U.S. stocks. That said, market-cap weighting can also lead to sector and single-security concentration, as witnessed at the height of the technology bubble. So, market-cap-weighted indexes’ greatest strength is arguably also their Achilles’ heel.

Low turnover is another key advantage of the fund’s broad market-cap-weighted approach. Lower turnover equates to lower costs and a lesser likelihood of taxable capital gains distributions. The average annual turnover the fund was 5% during the past five years. This compares to a median figure of 58% for its category peers. In fact, this fund hasn’t distributed a capital gain since its inception.

During the past decade through June 2017, this fund returned 7.2% annually, outpacing the U.S. large-blend Morningstar Category average by 1.5 percentage points. Much of this relative outperformance can be attributed to the fund’s sizable fee advantage. At 0.04%, the fund’s annual levy is a tiny fraction of the 0.90% median fee its category peers charge.

Process Pillar: Positive | Adam McCullough, CFA 07/31/2017
The fund employs full replication to track the S&P 500. This index effectively diversifies risk, promotes low turnover, and accurately represents its target market segment, supporting the Positive Process rating.

The S&P 500 has a slight quality tilt because of its conservative eligibility requirements. For instance, stocks must be profitable during the last four quarters before they are eligible to be added in the index. While qualifying stocks must pass some quantitative screens, a committee selects the final stocks for the index. And unlike other large-cap indexes, stock size is not the sole determinant of inclusion. Also, the index has higher free-float and trading volume requirements than similar indexes, which should help it avoid the least-liquid stocks. This committee structure gives the S&P 500 a greater degree of flexibility than indexes that follow more-mechanical rules, though this approach also reduces transparency.

Stocks are added and removed from the S&P 500 at the committee’s discretion, so it can be difficult to anticipate changes ahead of time. Because this is one of the most widely tracked indexes, changes tend to move stock prices. In January 2010, S&P announced Berkshire Hathaway would be added to the index, and Berkshire’s stock price appreciated more than 10% over the next few days.

This is a well-diversified offering that captures nearly 80% of the investable U.S. equity market. Its top-10 holdings represent just under 20% of the portfolio, half of the category average. Top holdings include household names such as  Apple ,  Microsoft ,  Amazon , and  Exxon Mobil . Sector weightings here are similar to the large-blend Morningstar Category average. The technology, healthcare, and financial-services sectors represent the fund's largest sector weightings, while the real estate, utility, and materials sectors carry the smallest weightings. The average market capitalization of the fund’s holdings is about 20% smaller than the category norm.

Many of the fund’s largest holdings are multinational firms, giving it substantial indirect international exposure. The portfolio managers use dividend reinvesting and derivatives to keep pace with the benchmark. The fund has historically used securities lending to generate additional income to offset expenses.

The portfolio managers can use index derivatives to keep the fund fully invested and manage redemptions. During the past decade through June 2017, the fund averaged only a 0.3% cash allocation, about a tenth of its average actively managed peer's.

Performance Pillar: Positive | Adam McCullough, CFA 07/31/2017  
The fund has generated strong risk-adjusted long-term performance compared with its large blend Morningstar Category peers. It earns a Positive Performance Pillar rating.

During the past 10 years through June 2017, the fund’s return topped the large-cap blend category average 1.5 percentage points each year. The funds’ cost advantage and efficient construction has contributed the most to its outperformance over the long run. Because the fund generates its edge from its low cost, its advantage is consistent. Over the trailing 13 years through June 2017, the fund’s rolling three-year returns landed in the top half of the category 99% of the time. And because it was fully invested, this fund performed worse than the category average during the bear market drawdown from October 2007 to March 2009. But its subsequent recovery more than made up for the slightly larger drawdown.

The fund benefits from securities lending and the use of derivatives to efficiently track its index. It has not distributed a capital gain over the prior decade. And its annualized tax-cost ratio was 0.4% over the past 10 years, compared with the 0.8% average of all S&P 500-tracking funds. That places this offering in top decile of S&P 500-tracking funds.

People Pillar: Positive | Adam McCullough, CFA 07/31/2017  
A well-equipped group manages all of Vanguard’s equity index funds. The team's extensive experience, deep bench of talent, and strong trading infrastructure underpin this fund's Positive People Pillar rating.

Donald Butler and Scott Geiger replaced Michael Buek as the named managers on the fund in April 2016. Buek, a veteran Vanguard manager, remains a co-head of the equity index group and trading teams. Butler is a principal of Vanguard Group, has been with the firm since 1992, and managed investment portfolios there since 1997. Geiger has been with Vanguard since 2006 and began managing portfolios in 2013. Butler and Geiger combine to co-manage four Vanguard funds including  Vanguard Extended Market Index , Vanguard S&P 500 Value , and  Vanguard Institutional Index .

According to the Statement of Additional Information, neither manager has money invested in the fund. Vanguard links the managers' compensation to operating efficiency, which helps keep costs low and aligns their interests with investors’. Minimizing costs and tracking-error are their primary objectives. Vanguard has automated much of this process and provides the managers with robust tools to handle flows, corporate actions, and benchmark changes.

Parent Pillar: Positive | 12/12/2016  
Vanguard has one of the mutual fund industry’s strongest corporate cultures and earns a Positive Parent rating. Its consistent messages to investors to keep costs low, diversify, and stay the course are reflected in the firm’s own behavior. Vanguard’s U.S. fundholders own the firm through small investments by each mutual fund, mitigating potential conflicts of interest that can exist at other firms that are serving two masters. Fund performance is strong overall: Over the past three-, five-, and 10-year periods, its Morningstar Success Ratios are greater than 70%--high among large, diversified fund families.

Over the past year, the firm has collected more than USD 200 billion in net inflows, thanks in large part to investors’ interest in passive investing. The firm's indexing and ETF prowess, low costs, and success in penetrating the financial-advisor sales channel all have fueled growth. Total assets under management now exceed USD 3.3 trillion, giving Vanguard a significant more-than-20% market share across U.S. mutual funds.

Vanguard has been a global player for years but has only more recently turned its focus to growing internationally. The firm is a large player in Australia, where it has the most history, but doesn't yet have the brand recognition and trust it enjoys in the United States in other parts of the world. While non-U.S. funds don't participate in the ownership of Vanguard, the firm's investorcentric culture extends globally.

Price Pillar: Positive | Adam McCullough, CFA 07/31/2017 
This is among the cheapest S&P 500-tracking funds. It charges a low 0.04% fee, well below the large-blend category median of 0.90%, supporting its Positive Price Pillar rating.

The fund’s minimum initial purchase is $10,000. The strategy’s ETF share class,  Vanguard S&P 500 ETF , also levies 0.04% per year, but does not require an initial minimum purchase beyond the cost of one share. The portfolio is also available in an Investor share class (VFINX) at a 0.14% annual fee and requires a $3,000 initial purchase.

The fund manages cash with index derivatives and generates additional income with securities lending, which benefits shareholders.

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Adam McCullough, CFA has a position in the following securities mentioned above: AMZN AAPL Find out about Morningstar's editorial policies.
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