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ETF Specialist

A Great Complement to an S&P 500 Fund

Vanguard Extended Market can be used to round out a large-cap portfolio, but mind its quirks.

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 Vanguard Extended Market ETF (VXF) is a great complement to an S&P 500 fund. The S&P Completion Index this fund follows is an amalgamation of two groups of stocks: All of the large-cap U.S. stocks that do not meet the inclusion rules of the S&P 500 and all of the mid-, small-, and micro-cap stocks that are too small for that index. In other words, it holds nearly all U.S. stocks except for constituents of the S&P 500, resulting in roughly 3,300 holdings.

This is not a typical mid-blend fund. Its larger exposure to micro-cap stocks brings the average market cap of the fund down to near small-cap territory. Smaller-cap stocks tend to be more volatile than large caps because they generally are less profitable and are less likely to enjoy competitive advantages. Their greater sensitivity to macroeconomic risks means that small caps are likely to underperform during market downturns. The fund also holds a small but eclectic collection of large caps, such as  Tesla Motors (TSLA) and  Las Vegas Sands (LVS), that are often more volatile than the average stock. Both of these factors drive volatility higher than the typical mid-blend fund. The volatility of return on the S&P Completion Index as measured by standard deviation was nearly 4 percentage points higher than that of the S&P 500 during the past decade, and the fund dropped 57.9% in the bear market from October 2007 to March 2009. That is a steeper decline than both the S&P 500 and the mid-blend Morningstar Category. Many of the large-cap stocks that the mutual fund share class of this fund owned in the year 2000 crashed when the tech bubble burst, sending the fund down 15.5% in a year when the mid-blend category was up 6.4%.

Despite these risks, the fund can be paired with an S&P 500 fund to provide complete exposure to U.S stocks. Whereas the S&P 500 covers about 80% of the total market value, this fund covers the remaining 20%. U.S. mid- and small-cap stocks have historically provided some minor diversification benefits. The correlation of the fund's benchmark with the S&P 500 was 0.94 from its inception in 2005 through September 2015.

Fundamental View
Mid- and small-cap stocks have been on a tear during the past 15 years, but the past may not be prologue here. The fund has beaten the S&P 500 by nearly 1.9 percentage points annualized during the past 15 years. That streak of outperformance has caused the portfolio's smaller stocks to appreciate to levels that look expensive relative to large caps. As of September 2015, the stocks in this fund that our analysts cover trade at a price/fair value of 0.97, while the less-volatile large caps in the S&P 500 trade at a more attractive price/fair value of 0.94. The dividend yield on stocks in the fund is about 1.7% versus about 2.4% for the S&P 500. They are also trading at a higher price/forward earnings ratio (18.7) than the S&P 500 (17.6). 

Mid- and small-cap stocks tend to be lower-quality than large caps. They are less likely to have sustainable competitive advantages, and they tend to be less profitable. Of the stocks in the fund that are rated by Morningstar equity analysts, just 9% have a wide Morningstar Economic Moat Rating, compared with 52% of stocks in the S&P 500. Stocks in the fund also employ more leverage, with a debt/capital ratio of 42% compared with 39% for large caps. Over the trailing 12 months through September 2015, they generated a lower average return on invested capital (6%) than those in the S&P 500 (13%).

The valuation premium of mid-cap stocks could be justified in part based on analyst expectations for faster earnings growth. According to consensus analyst estimates, earnings for the stocks in the fund are expected to grow at 12% during the next three to five years versus 10% for stocks in the S&P 500. Mid- and small-cap stocks may be attractive acquisition targets for large companies. Particularly in this environment of slower economic growth, large companies may look to acquire smaller companies to fuel growth.

Despite greater volatility and lower quality, mid- and small-cap stocks are more expensive. Rich relative valuations and pronounced volatility are good reasons to not have an overweighting in the segment.

Portfolio Construction
This fund tracks the S&P Completion Index, which includes nearly all U.S. equities traded on a major exchange except for those in the S&P 500. It is designed to complement this large-cap index with mid- and small-cap stocks without any overlap. While that means that the fund is mostly a mid- and small-cap portfolio, it includes a handful of large-cap stocks that do not qualify for inclusion in the S&P 500, such as stocks of recent IPOs or companies that do not meet the domicile, minimum float, or initial financial viability requirements of the S&P 500. The fund follows a combined replication and representative sampling construction methodology. It replicates the largest 80% of the index by market cap and then conducts portfolio optimization to gain exposure to small- and micro-cap names. This results in about 3,357 holdings from approximately 3,475 in the index. S&P uses some screening criteria to eliminate certain securities such as ADRs, limited partnerships, business development companies, and illiquid securities from its universe. The fund's average market cap of $3.3 billion is much smaller than the $6.5 billion average market cap for the mid-blend category and closer to the $2.5 billion average market cap for the small-blend category. The fund's exposure to real estate and consumer cyclical stocks is higher than the S&P 500, while exposure to consumer defensive, energy, and technology stocks is lower.

This ETF levies a 0.10% total expense ratio, putting it among the cheapest mid- and small-cap funds available. In practice, securities-lending revenue has helped this fund slightly beat its benchmark during the past three years.

Another option that matches up particularly well with the S&P 500 is SPDR Russell Small Cap Completeness ETF (RSCO), which includes all of the stocks in the Russell 3000 Index except for those in the S&P 500. While that ETF charges only 0.11%, it is much less liquid than VXF.

Investors have a wide variety of choices to obtain exposure to mid- and small-cap stocks.  Vanguard Mid-Cap ETF (VO) charges 0.09% and covers stocks smaller than the largest 70% of the market by market cap but larger than the smallest 15%.  Vanguard Small-Cap ETF (VB) (0.09% expense ratio) covers roughly 13% of the market after the largest 85%.

Those looking for exposure to the total market might consider  Vanguard Total Stock Market ETF (VTI) (0.05% expense ratio), which tracks an index that covers virtually every U.S.-traded stock.  Schwab U.S. Broad Market ETF (SCHB) charges 0.04% and tracks the Dow Jones U.S. Broad Stock Market Index, which covers the top 2,500 stocks, so it excludes the micro-cap group.

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Michael Rawson does not own (actual or beneficial) shares in any of the securities mentioned above. Find out about Morningstar’s editorial policies.