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Vanguard's Changes And Large-Cap ETFs

Paul Britt

Vanguard is changing the index tracked by its U.S. large-cap ETF. This got me thinking:Just what is a large-cap ETF, anyway? And is there a best way to define it?

The Vanguard Large Cap ETF (VV) will change indexes in the first part of 2013 from the MSCI US Prime Market 750 Index to the CRSP US Large Cap Index.

This change highlights the fact that—even within the most vanilla of market segments, U.S. large-cap equities—indexes and the ETFs that track them offer many choices for investors. Perhaps too many.

Here’s a quick view on how to approach the large-cap space.

1) Large Caps Vs. Total Market?

Instead of a large-cap ETF, consider owning the total market first. If you invest in a total market ETF, you’ll get all the market-cap sizes, including large-caps in marketlike allocations. What could be simpler?

Even if this approach is too basic for most, it’s a good starting point, with the idea that you reject a total market fund only because you intentionally want to vary from marketlike exposure in a particular way.

2) How Many Buckets?

If a total market approach is too blunt, the next question is, How finely do you want to parse the market? Choices abound, including mega, large, mid, small and micro.

One approach is to put these labels aside at first and simply focus on how many buckets you think you want. Maybe two is enough—large and small. It’s OK to think outside the style box that suggests large, mid and small is the only suite of choices.

In my view, investors should reach for the more precise increments only to the extent that they have a view on how that particular segment might perform.

The point here is that the large-cap definition doesn’t occur in a vacuum. If you’re splitting the market into fewer buckets, your large-cap’s range will look bigger.

3) Avoid Unwanted Overlaps Or Gaps

One key aspect to watch for is the names that each issuer gives to its various size buckets. One person’s mega-cap is another person’s large-cap.

Confusion over names is more than a semantic difference:Sometimes buckets overlap. The CRSP large-cap index, for example, essentially combines the CRSP mega-cap and midcap indexes.

An investor wanting three nonoverlapping buckets in the CRSP indexes would need to choose mega, mid and small, and not the large, mid and small, since the latter would lead to double exposure of midcaps.

That’s not an indictment of the CRSP index family—many providers offer overlapping coverage in the name of more choices for investors.

There’s no standardization across indexes and ETFs on this point, so look beyond the name to see what the coverage range actually is, whether expressed by rank (top 750, for example) or by percentage (top 70 percent).

Complete, nonoverlapping coverage won’t matter to some investors, like those making a tactical allocation to a particular segment. The point is to avoid unintentional overlaps or gaps in exposure.



4) Break Points

My colleague Ana Kostioukova recently touched on how some indexes use number of stocks and others use cumulative market cap to define a break point between size buckets.

The two methods are related. For example, the top 300 might get you about the top 70 percent of the market and the top 750 names might get you the top 85 percent. While the distinction over the best way to define the break point matters, more important, in my view, is dialing in what the desired break point is, regardless of how it’s defined. This gets back to point 2 above.

One approach is to consider market risk. All else being equal, a large-cap ETF that holds fewer names or a smaller percentage of the total market will have lower market risk. Conversely, a fund that reaches further down the market-cap spectrum (whether measured by more stocks or a higher percentage) will have higher beta.

The abundance of large-cap choices can either empower or confuse investors.

Presumably, you’re allocating to large-caps and not to the broader market for a reason. Make sure the ETF you choose is consistent with that reason. Avoid unintended allocations by comparing how the large-cap ETF you’re considering fits with the rest of your portfolio.

The bottom line is this:Look beyond the name of an ETF to understand what part of the market it actually covers.

At the time this article was written, the author held a position in VV. Contact Paul Britt at pbritt@indexuniverse.com.


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