This strategy beats a total stock market fund and gives you more diversification – MarketWatch

More and more lately, Im hearing the praises of total market funds as alternatives to S&P 500 index SPX, +0.41% funds.

Unfortunately, many advocates of total market funds dont realize they arent fundamentally different from S&P 500 funds.

Fortunately, theres an even better alternative, which Ill get to.

As you probably know, the S&P 500 is made up of 500 of the largest publicly traded companies in the United States. But what many people do not know and understand is that the index is capitalization-weighted.

Heres what that means: The index is overwhelmingly dominated by the stocks of companies with the highest market capitalizations. (Market capitalization is equal to the stock price times the total shares outstanding.)

Sure, there are 500 stocks in the index, and that should provide quite a bit of diversification. But in fact, a handful of megacompanies like Microsoft MSFT, +0.56%, Apple AAPL, +1.23%, Google GOOG, +0.33% GOOGL, +0.41%, Amazon AMZN, -1.09%, Berkshire Hathaway BRK.A, +0.64% BRK.B, +0.73%, Exxon Mobil XOM, +0.23%, and J.P. Morgan Chase JPM, +0.80% account for a large part of the ups and downs of the index.

Indeed, the 10 largest companies (2% of the stocks in the index) make up more than 20% of the index.

The S&P 500, in other words, is dominated by a few companies in a few industries. All of these, essentially by definition, are large-cap growth stocks.

But one commonly-suggested remedy for greater diversification, the total market index fund, isnt a whole lot better.

Standard & Poors has a Total Market Index (TMI) that, according to the company, is designed to track the broad equity market, including large-, mid-, small-, and microcap stocks.

That might sound like a welcome dose of diversification, but it isnt.

The TMI, like the S&P 500, is also capitalization weighted. So yes, it includes small-cap and microcap stocks. But their contribution to the index itself is minuscule.

Heres an analogy from American history: The Boston Tea Party was a big deal politically. But it didnt do much to change the flavor of the water in Boston Harbor.

The widespread misunderstanding of TMI funds came to my attention recently as I worked with some of the leaders of the FIRE (financial independence, retire early) movement.

One of their heroes, J.L. Collins, has written a book that is popular among FIRE members, recommending the TMI VTSAX, +0.43% (instead of the S&P 500) as the index on which they should build their portfolios.

I have spoken to many TMI advocates over the years. When I go through my presentation about the benefits of investing in value stocks and small-cap stocks, they are pleased, since they have been taught that they have the proper amounts of these asset classes.

But it just isnt so.

In either index, the stocks of the largest companies are responsible for most of the gains or losses each day, each week, each month, and each year. In fact, its not unusual for the biggest 50 companies to be responsible for the majority of the behavior of these indexes.

In S&P 500 index funds, investors get almost exclusively large-cap growth and large-cap value. TMI index funds are similar as are their returns.

Consider: In a recent study we compared the returns of many asset classes over a series of different periods.

Heres some of what we found:

From 1928 through 1974, the S&P 500 had a compound return of 7.8%, the TMI 7.3%.

From 1975 through 1999, the S&P 500 return was 17.2%, the TMI 17.3%.

From 2000 through 2018, the returns were 4.9% for the S&P 500, 5.2% for the TMI.

For the entire 91-year period, the S&P 500 compounded at 9.7%, the TMI at 9.5%.

(These and the other return figures Im citing do not include any fund expenses.)

The conclusion seems obvious and hard to deny: There wasnt a large performance difference between S&P 500 and TMI.

As I mentioned, theres a better way to obtain the real value of the total U.S. stock market: Diversify by adding important asset classes.

The four most important U.S. equity asset classes are large-cap growth, large-cap value, small-cap growth, and small-cap value.

If I had to pick just one major U.S. asset class to use as a diversifier against either the S&P 500 or the TMI, it would be small-cap value stocks. (In fact, Im finishing up work on writing a book on that very topic.)

For the four periods I discussed above, heres how small-cap value stocks performed, compared with the TMI.

From 1928 through 1974, small-cap value 9.1%, TMI 7.3%.

From 1975 through 1999, small-cap value 22.3%, TMI 17.3%.

From 2000 through 2018, small-cap value 11.2%, TMI 5.2%.

For the 91 years 1928 through 2018, small-cap value 13.1%, TMI 9.5%.

You dont have to go way out on a limb to get the benefits of small-cap value investing.

Our studies show that, over a typical 40-year time horizon for retirement investing, if your equity portfolio is mostly in an S&P 500 fund, a TMI fund or a target-date retirement fund, shifting just 10% of that into small-cap value stocks can boost your earnings by 25% or more over those 40 years.

But heres an even better idea for the equity part of your portfolio: Ditch the TMI or S&P 500 fund, and diversify equally among large-cap growth, large-cap value, small-cap growth, and small-cap value.

All these asset classes are available in low-cost index funds. This gives small-cap stocks and value stocks a chance to actually make a difference in overall returns.

From 1970 through 2018, that combination of four asset classes would have produced a compound return of 12.7%, compared with 10.2% for either the S&P 500 or the TMI.

That difference might not seem overwhelming, but with compounding over those 49 years, it would triple the return in dollars.

This may not be for everybody. But its certainly worth thinking about.

For something else worth thinking about, listen to my latest podcast: Which does better in bear markets: actively managed or passively managed funds?

Richard Buck contributed to this article.

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This strategy beats a total stock market fund and gives you more diversification - MarketWatch