By Paul A. Merriman, MarketWatch
More and more lately, I’m hearing the praises of “total market” funds as alternatives to S&P 500 index /zigman2/quotes/210599714/realtime SPX +0.91% funds.
Unfortunately, many advocates of total market funds don’t realize they aren’t fundamentally different from S&P 500 funds.
Fortunately, there’s an even better alternative, which I’ll 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.
Here’s 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 /zigman2/quotes/207732364/composite MSFT +1.21% , Apple /zigman2/quotes/202934861/composite AAPL +1.93% , Google /zigman2/quotes/205453964/composite GOOG +0.94% /zigman2/quotes/202490156/composite GOOGL +0.94% , Amazon /zigman2/quotes/210331248/composite AMZN +0.64% , Berkshire Hathaway /zigman2/quotes/208872451/composite BRK.A +1.16% /zigman2/quotes/200060694/composite BRK.B +1.37% , Exxon Mobil /zigman2/quotes/204455864/composite XOM +1.61% , and J.P. Morgan Chase /zigman2/quotes/205971034/composite JPM +1.49% 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, isn’t a whole lot better.
Standard & Poor’s 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 isn’t.
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.
Here’s an analogy from American history: The Boston Tea Party was a big deal politically. But it didn’t 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 /zigman2/quotes/202568178/realtime VTSAX +0.91% (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 isn’t 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, it’s 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.