Last Updated Feb 3, 2010 9:24 AM EST
Of course you are right about these two flaws in the S&P 500, and I agree with your conclusion about "a better way."
But we're left to explain why, over history from 1928 on, the annual return in the S&P 500 has been 10.4 percent while the return on the Total Stock Market has been 10.2 percent (see the Little Book of Common Sense Investing).
Food for thought.
I'll confess, as any Boglehead will tell you, that it was pretty thrilling to get a hand written note from Jack Bogle. As always, he raises an interesting point by stating the S&P has outpaced the total U.S. stock market since 1928 by 0.2 percent annually. MoneyWatch writer, Nathan Hale, also pointed out a similar phenomenon. Food for thought, to be sure, and here's what it got me to thinking on the issue.
History of the S&P 500
There is no doubt in my mind that Mr. Bogle is giving the best and most unbiased view of S&P returns since 1928. Unfortunately, the data it's based upon is imperfect at best, since accurate data is hard to come by the older it becomes.
In 1928, the S&P index was comprised of only 90 companies. It didn't get to its current state of 500 companies until 1957. So comparing a total index with data that may contain inaccuracies to the S&P index, which contained a vastly different number of companies in that period, may yield some unintended consequences in the outcome.
Performance of the two funds
Like any good math geek, I could pick periods of time to compare the S&P 500 performance to the Total Stock Market performance to give evidentiary support for either point. I decided to go back and compare the actual two funds from the time both existed. The Vanguard Total Market Index fund (VTSMX) was introduced on April 27, 1992, and earned an average return of 8.10 percent annually through January 15, 2010. This compares to a 7.98 percent annual return for the Vanguard S&P 500 Index fund (VFINX) during the same period. The difference of 0.12 percent annually is hardly proof that the Total Stock Market Fund will outperform. Over the next year, if small cap stocks do horribly relative to large cap, that slight edge Total Stock has over the S&P 500 could turn around.
Bogle is right -- on both issues
I suspect that Jack Bogle brought us the Total Stock Market Index Fund because he thought it was a better vehicle than only owning the 500 largest stocks. It offers investors more diversification and lower turnover, since the total stock index fund doesn't have to trade based on any change by Standard and Poor's.
He's also right, however, that it's far from a slam dunk that a total stock market fund will outperform the S&P 500 fund. In fact, the performance variation between the two should never be large since the S&P 500 comprises about 80 percent of the value of the total market fund.
The S&P 500 fund is a great way for investors to harness the return that capitalism has to give. In fact, I think it's better than 99.9 percent of mutual funds out there. A total stock market fund is just slightly superior.
While I'm willing to bet that the total stock market fund will outperform the S&P 500 over the next decade, I'd also put the odds of me being wrong at just under 50 percent. I'd be shocked, however, if one beat the other by very much.
And most importantly, I'd like to thank Mr. Bogle for giving investors two great ways to harness the capitalism from U.S. based companies.
Prologue - Jack Bogle explains the logic of the Total Stock Market Index Fund
I interviewed Jack Bogle last week on his 10th anniversary edition of Common Sense on Mutual Funds, which I'll write about shortly. We spoke briefly about the issue of the Total Stock Market Index Fund vs. the S&P 500. Mr. Bogle noted that trying to determine whether a total stock market fund is better than an S&P 500 fund, and by how much, is ultimately insignificant compared to the differences between broad low-cost index funds and actively managed funds, which embrace speculation rather than long-term investing. I totally agree.
On October 26, 2000, Jack Bogle had the following to say to the Investment Analysts Society of Chicago.
We formed the first S&P 500 Index fund in 1975, and then in 1987 pioneered the completion ("Extended Market") index fund, tracking the small- and mid-cap stocks unrepresented in the S&P 500. The idea: To enable investors to make a commitment to the entire stock market, which I consider as the full fruition of the index fund concept. But adjustment of stocks between the two index funds was required as stocks moved in and out of the 500, creating portfolio turnover and potential tax-inefficiencies. So, in 1992 we created the all-in-one Total (U.S.) Stock Market Index Fund.
MORE ON MONEYWATCH
When a Stranger Calls with a Great Investment Why it Wasn't a Lost Decade For Investors How to Protect Your Investments from Yourself It's Not How Much You Pay in Costs, It's the Total Return That Matters An Interview with Ric Edelman - Is High Cost Indexing an Oxymoron?