Diversification
Diversification is a survival tool. In the case for Christopher Columbus, he diversified his ship voyage routes to increase the chance of success, while reducing risk from headwinds, storms, disease, and other issues that arise. In modern manufacturing, multi-sourcing a supplier base decreases the risk of late or low-quality batches. I believe diversification brings you closer to solid returns, while significantly reducing risk of the unknown. Investment theory pioneer Harry Markowitz famously called diversification “the only free lunch in finance”. I recently wrote an article on my favorite investment play in (VT) and why I believe it is a better long-term option versus a 100% US index. But what if you strictly bleed red, white, and blue in your investment decisions? (VOO) and (NYSEARCA:VTI) are solid options. But which one is better for an ETF ("Exchange-Traded-Fund") following a 100% US-based index?
What is the difference?
Both funds exhibit a 0.03% expense ratio. This means in a 1 million dollar retirement portfolio, you will pay $300 in expenses a year. Compare this to a mutual fund, where expenses can range from anywhere to 0.5% -1% or more, you'd paying be $5,000 to $10,000 or more in expenses per year. Also, the vast majority of mutual don't even match or beat the broad index over the long run anyways, so it's clear VOO and VTI are excellent candidates.
The differences between the two are the number of holdings. VOO follows the S&P 500 and will only match around the 500 largest companies by market at market cap-weight. Whereas VTI doesn't care and holds virtually every publicly traded company in the US at market weight. This makes sense when we look at the top 10 holdings in VTI of 26.29% versus 30.76% for VOO. since VTI has many micro and small cap holdings, the top 10 assets will be slightly diluted. It also makes sense when we look at the turnover of 3.00% of VTI versus 2.00% for VOO because smaller cap stocks generally carry a higher risk of bankruptcy compared to large caps which allow new small caps to enter. However, there is still some turnover for VOO as medium cap companies fluctuate in market cap size and new positions are rolled in and out of the index. Overall, these turnover rates are extremely low and not really something to be concerned about. Beta is a measure of risk through historical price fluctuations. Technically, VTI is more "riskier" in this sense, but again, these values are so close, they might as well be treated the same.
Even when we venture to the dividends, the performance is very similar with VTI touting a 1.57% yield and VOO with a 1.59%. The growth on VOO has been slightly higher versus VTI, but still respectful for the two.
The price return is probably the most important factor for retail investors. Although, I would argue this is the last place you should look for a broad index. That being said, VOO has a total return of 205.67% compared to VTI of 187.94% over the last 10 years. VTI even had times of slightly more drawdown, but for the most part, the price return is very similar.
Why VTI?
So this begs the question: Why even bother with VTI if VOO has slightly outperformed all metrics compared to VTI?
Let's remember that past performance does not indicate future expectations. Yes, VOO has outperformed VTI, but this does not guarantee it will continue to do so. Even when we compare these two funds to (IWM), an ETF that tracks small caps through the Russell 2000, we see there were many stretches that small caps have outperformed large caps over the years.
By investing in VOO, you are less diversified and limit your portfolio to only large cap stocks. This has proven to be a prudent strategy the last 20 years or so, but will it continue? Or would you rather be more diversified and have a small portion of your basket dedicated to some smaller companies that may become the next Apple? I know I would choose the latter.
Philosophy of Index Investing
Numbers aside, I think VTI follows the philosophy of Index Investing closer than VOO. If "buying the haystack" and moving on with your life is your strategy, then why not buy the bigger stack in VTI? By buying VOO, you are eliminating your fair share at owning a possible needle. Although I'd say buying either and never selling it is an excellent investment strategy, I believe VTI embodies the idea of diversification much better.
M Value Investing Research
Mitchell is a mechanical engineer and MBA student. His personal portfolio consists mostly of a broad index at any given moment. However, he still likes companies that perform well on key metrics and will enter a small position if they are well-price through corporate valuation methods.
Analyst’s Disclosure: I/we have no stock, option or similar derivative position in any of the companies mentioned, and no plans to initiate any such positions within the next 72 hours. I wrote this article myself, and it expresses my own opinions. I am not receiving compensation for it (other than from Seeking Alpha). I have no business relationship with any company whose stock is mentioned in this article.
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