S and P 500 Index and the Total Stock Market Index

Many of you may be asking the same thing, given that many Canadian investors have turned to indexes since the advent of exchange-traded funds to obtain exposure to U.S. equities.

Market Capitalization Of Each Company

It is essential to understand that the S&P 500 is a type of stock market index that tracks the performance of 500 of the largest publicly traded firms in the United States based on the market value of their common shares. Index weights are calculated by taking into account the market capitalization of each company, which is calculated by multiplying the number of outstanding shares by their current price. Virtually all the money invested in U.S. Equity ETFs is in funds that track this index.

Cap-Weighted Indices

On the other hand, when we talk about total stock market funds, we're talking about both large-cap equities and the many small- and mid-cap stocks that aren't included in the S&P 500. The MSCI U.S. Broad Market Index and the Dow Jones U.S. Total Stock Market Index are standard cap-weighted indices that total market funds use to track the performance of all publicly traded U.S. stocks. To help you pick the right index fund, we'll examine the pros and cons of the two most popular types.

Compositional Variations

Now that we know a total stock market index fund has more equities than the S&P 500, you may be surprised to learn that the difference between the two is not as significant as you initially thought. Since the stocks included in the S&P 500 account for over 80% of the total market value of U.S. equities, there is a great deal of overlap.

However, the overall stock market index fund is more diversified because it includes smaller stocks (representing roughly 20% of the market cap). Investors with a diversified portfolio for small-cap firms may not need to add the S&P 500 fund's focus on large and mid-cap companies. A mutual fund seeking diversification would do well to follow the total market index because it represents the most significant potential breadth of the U.S. equity market.

Average Market

We may compare the portfolios of two funds that seek to mimic the performance of these indices by examining their individual holdings. The iShares S&P 500 Index XUS ETF, which mirrors the S&P 500, has a $65.7 billion average market cap due to its holdings of 500 firms. Compared to that, the average market cap of the stocks in the Vanguard U.S. Total Market ETF VUN, which follows the CRSP U.S. Total Market Index, is only $35.7 billion.

Publicly Listed Equities

In September, Standard & Poor's announced that Advanced Micro Devices AMD would be removed from the index because of the company's small market valuation (AMD was added to the S&P MidCap 400 Index). However, the great majority of publicly listed equities in the United States meeting minimal liquidity standards are tracked by the CRSP U.S. Total Market Index, which now stands at roughly 3,600 securities.

As a bonus, the accessibility of S&P 500 stocks makes it easy for funds to track the index. Due to the significant transaction costs associated with investing in tiny publicly traded issues, mutual fund providers cannot do so. To save trading expenses, total market funds may utilize a representative sample technique to mimic the performance of an underlying index rather than buying and selling each stock in the index individually.

The level of effectiveness varies.

The question, therefore, becomes, how do index funds that follow the S&P 500 compare to those that follow the whole U.S. stock market? To put it briefly: not much. Here is a table that summarizes the annualized returns of each fund type over a few different time intervals. Since the Canadian debut of the Vanguard total market ETF wasn't until August 2013, this comparison focuses on the U.S. versions of these funds, which have minimal fees and long track records. All dollar figures here are listed for convenience.

Associated With Index

Investors who prefer a hands-off strategy will find that S&P 500 index funds and whole stock market ETFs offer good exposure to a wide range of U.S. companies. The costs associated with index funds are often lower than other investment vehicles. Whether you can stomach the slightly higher volatility associated with total market funds in exchange for the chance of superior long-term returns is the deciding factor between total market and other forms of index funds. Yes, it depends on the individual, but it's an interesting question.