For investors who do not utilize professional management, research has confirmed that the average investor is better served by using passive mutual funds and ETFs. If investors have no interest in making changes, even quarterly or semiannually, they have a greater probability of success if they simply invest their money in a low-cost index.
Actively managed funds generally have a defined objective, and they may underperform when their mandate is not currently successful in the market. For example, the management of Vanguard Health Care (VGHCX) has had excellent historical performance, and dramatically outperformed the market indexes, earning a 4-star rating from Morningstar. However, in 2016, the fund underperformed both the S&P 500 and the Dow Jones Industrial Average. As it is an actively managed fund, with a specific investment requirement, it’s no surprise that it would underperform the broader market when the healthcare sector is lagging.
A position like this may make sense when your portfolio is being diligently monitored. With active management or dedicated attention to the holdings of actively managed mutual funds, an investor can perform significantly better the broader market. Funds with a specific focus or identifiable philosophy can be bought and sold as the market dictates. Nevertheless, if investors are not reviewing their holdings, investing in targeted funds can hamper returns. Passive strategies that invest in index funds over the long term can be a better option for such investors.
Strategies benchmarked to broad market indexes can provide stable risk-adjusted returns relative to the broader market. Index funds also provide greater diversification as they generally hold a broad range of securities, limiting stock-specific risk. They also have a tax advantage because they distribute capital gains less often and are typically meant to be held over the long term, providing lower portfolio turnover that reduces trading expenses.
This low-cost strategy provides an option for investing in a broadly diversified portfolio benchmarked against a wide variety of market indexes than can actively managed funds, though it may sacrifice greater gains.
Investors seeking a diversified portfolio in a single fund should consider the large-blend category Vanguard 500 Index Fund (VFINX) as a core holding. Established in 1976, VFINX was introduced as the industry’s first passive index mutual fund for individual investors. It provides a low-cost way to achieve a diversified exposure to the domestic equity market. The fund invests in the 500 largest companies in the country, which represent a cross section of industries and sectors, striving to replicate the return of the S&P 500 Index.
Investment Strategy
Led by Donald Butler and Scott Geiger, fund managers use a full replication strategy to track the underlying index, which promotes diversification, lowers risk and fosters low turnover. Because of its conservative eligibility requirements, the index has a tilt toward higher-quality names. The fund’s average market cap weighting approach pulls the portfolio toward giant- and large-cap stocks. This weighting approach, which is like that of its large-blend category peers, is beneficial during bull markets when larger-cap names are providing leadership. The fund invests substantially all its assets in stocks contained within the index, holding each stock with approximately the same weighting found within the benchmark. The low fees and diverse, well-constructed portfolio should enable the fund to continue its history of superior risk-adjusted returns.
Portfolio Construction and Holdings
The large core fund has $26.7 billion in AUM, with 98.79 percent allocated to medium-, large- and giant-cap stocks. The fund has minimal exposure to small-cap shares. Its average market cap of $80 billion is higher than the $61 billion average of the benchmark. The mutual fund’s P/E ratio of 18.51 and price-to-book ratio of 1.93 are in line with those of its benchmark and category. When compared with the underlying index, the fund is slightly overweight consumer defensive, energy, technology and healthcare shares, while being marginally underweight basic materials, real estate and industrial names. The top 10 holdings represent 19.1 percent of AUM. They include Apple, Microsoft, Alphabet, Exxon Mobil and Johnson & Johnson. The next five largest holdings, in declining order, are Berkshire Hathaway, JPMorgan Chase, Amazon, General Electric and Facebook.
Historical Performance, Fees and Expenses
The fund’s investment strategy, sector weightings and low turnover have enabled it to return an average of 6.87 percent per year for the 10-year period. However, it performed slightly worse than the 6.99 percent return of the S&P 500 over the same period, due in part to the management expense. The low 0.16 percent turnover rate lessens the likelihood of taxable capital gains distributions. This rate is approximately 80 percent less than the category average. Another benefit to investors is the fund’s 0.05 percent expense ratio, which is low compared with the category average of 0.79 percent.
For the past three-, five- and 10-year periods, VFINX has earned above-average return ratings from Morningstar. The fund’s one-, three- and five-year returns of 20.00, 10.71 and 13.73 percent, respectively, are slightly higher than the average of the category. With a three-year beta and standard deviation of 1.00 and 10.46, matching the underlying benchmark, VFINX earns an average Morningstar risk rating. Over the past 10 years, the fund has shown excellent tax efficiency and a minimal tracking error.
VFINX has a minimum initial investment of $3,000. It is also available as Admiral Shares using the ticker symbol VFAIX. Although it requires a higher initial investment of $10,000, VFAIX has an even lower expense ratio of 0.05 percent. Investors interested in this fund may also consider Vanguard’s S&P 500 ETF. Trading under the symbol VOO, it also has an expense ratio of 0.05 percent, which is 95 percent lower than the category average.
Recommendation
For investors seeking a large-cap, low-cost investment option, VFINX is an excellent solution. It provides diverse exposure to a broad range of sectors and is a sound core holding. Currently we have issued a Buy recommendation, with a Ranking of 89.