“Total” Market indexes

globeIn 1986 John Bogle and Vanguard introduced a bond market index fund. In what was to become a brilliant marketing strategy, Bogle labeled the fund as the Vanguard Total Bond Market Index Fund.

Bogle returned to the “total” market branding strategy,  with the 1992  introduction of a broad US stock market index (designated the Vanguard Total Stock Market Index) and again with the 1994 introduction of a broad international stock market index (branded as the Vanguard Total International index).

While each of these funds provide broad market exposure, none provide access to the complete market opportunity set implied by the “Total” moniker. This is true for U.S. bond market index funds; historically true for international index funds, albeit with a continuous broadening of market coverage over the years; and much less true for U.S. stock market indexes, although with a recent modest erosion in market coverage.

While the “total” appellation  contains a dollop of poetic license, this branding has proven to be a major success, specially among investors seeking to simplify investment portfolios by limiting the number of funds they hold.

A rose by any other name would smell as sweet; but one might well imagine investors  responding somewhat differently were the funds labeled, as is common, by direct reference to the tracked index:

  • CRSP U.S. Total Stock Market Index Fund
  • FTSE All-World ex U.S. Index Fund
  • Barclay’s U.S. Aggregate Bond (free float) Index

How many novice investors would immediately think, “Ah, how simple!” ?

Or using  an alternative adjective:

  • Core U.S. Bond Index Fund
  • Core U.S. Stock Index Fund
  • Core International Index Fund

How many investors might feel a push toward tinkering beyond the core?
Lets look under the hood at each of the total market funds to see what they hold and how they stack up when measured against the total market.

Total bond market

Funds purporting to be “total” U.S. bond market indexes predominantly  track the Barclays U.S. Aggregate bond index (or the free-float version of the index).

 SIFMA (Securities Industry and Financial Markets Association) provides market data on existing U.S. bonds.

The table below shows the following percentage make-up of existing issues of U.S. bonds in comparison with the Barclay’s Aggregate Index (2014 data). Barclay’s combines mortgage-backed securities  and asset-backed securities into a single “securitized bond” category. Asset-backed securities currently make up less than one percent of the index. As can be seen, the universe of U.S. bonds is not replicated by the Barclays Index.

 Bond market allocation

Bond type SIFMA Barclays Agg
Treasury 32.16% 35.70%
Corporate Debt 26.00% 23.00%
Mortgage Related 23.36% 31.30%
Municipal 9.71% 0.00%
Fed Agency 5.17% 10.00%
Asset-Backed 3.60%  –

(see google drive spreadsheet link for complete data)

Barclays Aggregate  and Universal Indexes

The chart (click to enlarge) shows the bond allocation for the Barclays U.S. Aggregate Bond Index in 2014. The Barclays index includes:

BarclaysAggBond
Barclays U.S. Aggregate Bond Index (2014)
  • U.S. treasury bonds and notes
  • U.S. government agency bonds and notes
  • Investment grade corporate bonds and foreign corporate dollar bonds issued in the U.S.
  • Mortgage-backed securities and asset-backed securities

The Aggregate index does not include the following additional segments of the US bond market:

BarclaysUniversalbond
Barclays U.S. Universal Bond Index (2014)
  • High yield bonds– the index excludes bonds with below investment grade credit quality. Interestingly, Barclays provides a U.S. Universal Bond Index (click image to enlarge) which adds the Barclays U.S. High Yield Corporate Bond Index, along with U.S. dollar Emerging Market bonds.
  • Inflation-indexed treasury bonds and floating rate bonds– the index only includes fixed income coupon paying bonds. If added to an enlarged Universal index, inflation-indexed treasuries would occupy about 2% of the index.
  • Municipal bonds– the index does not include tax-exempt municipal bonds.

The table below provides a comparison of the  Aggregate and Universal Indexes.

Bond type Barclays Agg Barclays Universal
Treasury 35.70% 30.00%
Mortgage Related 31.30% 27.00%
Corporate Debt 23.00% 22.00%
Fed Agency 10.00% 8.00%
Asset-Backed
Emerging market  0.00%  7.00%
High Yield 0.00% 6.00%
Municipal 0.00% 0.00%
 Expanding (or curtailing) a U.S. total bond allocation

Investors can broaden (or curtail) a portfolio bond allocation by adding or limiting bond selection. The broadest U.S. bond index fund tracking the U.S. bond markets is the iShares Core Total USD Bond Market ETF, tracking the Barclays U.S. Universal Bond Index.
Investor additions to a “total” bond index fund, subject to an investor’s allocation wishes, can include:

  • Adding a high-yield bond fund
  • Adding a treasury inflation-indexed bond fund
  • Adding a floating rate bond exchange-traded fund
  • Adding a municipal bond fund

One should note that an investor can decide to limit bond allocations to a specific bond asset class. Yale endowment investment manager David Swensen and Harry Browne’s Permanent Portfolio restrict bond allocations to treasury bonds in their portfolio recommendations. Investors subject to high tax rates may elect to hold municipal bond funds. Investors wishing to protect against inflation may desire to hold inflation-indexed bonds.

A more complete market capitalization weighted total bond index fund that would add municipal bonds to the universal bond index would not be a practical market cap weighted mutual or exchange-traded index fund. Tax regulations specify that in order for a fund to pass through tax-exempt municipal bond interest to its investors, the fund must hold a minimum 50 percent allocation to municipal bonds. This allocation is far above the historical range of municipal bond market cap weighting in the SIFMA database:

Municipal bonds market weight (1980-2014)

High 23.01%
Low 9.71%
Mean 14.74%
Median 12.43%
Total stock market

U.S. total stock market indexes provide exposure to almost all of the publicly accessible equity securities in the U.S. To accomplish this exposure, U.S. equity indexes usually restrict coverage to common stock shares. The U.S. total market indexes cover all but a small sliver of the public equity market.

The exchanges trade many more investment securities besides common stocks. These securities include exchange-traded funds; closed-end funds; preferred stock; convertible securities; warrantsADRs (American Depositary Receipts) and various forms of partnerships and trusts.

Some of these  excluded securities  provide access to important segments of the  economy,  such as the master limited partnerships that transport the nation’s energy resources and the Business Development Companies (BDCs) that supply venture capital for small and midsize firms. These represent 50 to 100  excluded businesses.

  A closer look at master limited partnerships

These securities are dominated by the business enterprises that transport the nation’s energy supplies: oil, natural gas, and coal.

These exchange-traded partnerships pass along the income derived from the nation’s grid of oil and gas pipelines. The major reason for exclusion from market index benchmarks is the highly-convoluted and complex  IRS tax requirements for filing partnership tax returns.

 A closer look at Business Development Companies

From their creation in 1980 to 2014 BDCs were included in U.S. total market indexes. A business development company is a management company designed to help grow small and mid size companies (mostly privately owned companies). BDCs are similar to venture capital funds and private equity funds, but are public stocks listed on the New York and NASDAQ stock exchanges. Usually venture capital and private equity are investment allocations reserved for the nation’s large endowment funds and institutional investors.

The crux of the issue regarding BDCs is the recent SEC decision that since a BDC is structured and regulated very much like a mutual fund, certain business expenses must be passed on as additional “acquired fund fees” in the reported expense ratios of the mutual fund or exchange-traded fund holding the stock. This is the reason for DBCs now being excluded from the market index.

If investors want to add these companies to their equity allocations,  there are indexed exchange-traded funds that can fulfill the desire.

Investors can access coverage to exchange-traded master limited partnerships through the Alerian MLP ETF (AMLP), which provides investors with 1099 tax documents, rather than the customary K-1 forms typical for partnership tax reporting. However tax complexity is still quite high, so most investors should exercise caution and diligence before making an investment.

Business Development Companies can be added through the BDC Income ETF (BIZD) which has an exorbitant acquired fund fee, but the actual expense of managing the fund is 0.40%.

A shrinking market
Wilshire5000Index

Source: Wilshire Associates

One should also note that the number of companies making up U.S.  total stock market indexes has been declining since 2000.
Over this period, companies have been delisted, due to bankruptcy and deteriorating financial fundamentals; through mergers and acquisitions; and through companies being privatized out of the public market arena.

StockmarketIPOs

Source Wilshire Associates

In addition, over the 2000-2014 period the pace of initial public offerings of new companies has slackened.
(See table below and charts on the right showing results for the Wilshire 5000 Index: click to enlarge).

Wilshire 5000 Index

 Year Number of companies
2002 5872
2004 4989
2006 4961
2008 4593
2010 4008
2012 3687
2014 3711
Total International stock market

The most venerable index of international stocks is the MSCI EAFE Index.  While the EAFE index is tracked by a large number of index funds and exchange-traded funds,  it is not a reflection of a “total” international index.

The EAFE index covers national markets that are classified as developed markets.  The index does not provide coverage of the following segments of the international stock market:

  • International small-cap stocks– the EAFE index covers large-cap and mid-cap stocks;
  • Canada– the EAFE excludes Canada from the index;
  • Emerging market stocks– the index excludes stock markets classified as emerging market stocks;
  • Frontier market stocks– the index excludes stock markets classified as frontier market stocks.

In 2014, the MSCI-EAFE index covers slightly less than 60% of the international stock market universe.

International stock market capitalization weights

Small-cap 14.50%
Canada 7.35%
Emerging 18.03%
Frontier 0.60%
Total 41.89%
Broadening international stock market allocations

Vanguard introduced international stock index funds to individual investors in 1992, and introduced a broad market international index fund in 1994, which it labeled the Vanguard Total International Stock Market Index.

The index added a partial subset of the MSCI Emerging Market Stock Index to the MSCI EAFE developed markets. Thus, this “total” market index lacked exposure to the full set of emerging market stock markets, Canada, and small-cap international stocks (2005 marked the inception of frontier market stock indices).

In 2006, Vanguard broadened the market coverage of its “total” international fund by increasing the coverage of emerging markets stock markets to the full set of emerging market stock markets included in the MSCI Emerging Markets Stock Index.

In June 2013, Vanguard extended the reach of the fund by changing the tracked index to the FTSE Global All Cap ex US Index, which added small-cap international stocks and the Canadian stock market to the fund’s coverage of the international stock market. 

The current fund allocation lacks coverage of frontier stock markets. Investors wishing to extend market coverage to frontier markets can do so by adding a frontier market index exchange-traded fund to their portfolios. The lowest cost option in this area is the iShares MSCI Frontier 100 ETF (FM) , tracking the MSCI Frontier Markets 100 Index.

Notes
About

Barry Barnitz, administrator of both the Bogleheads® wiki and of Financial Page, a Bogleheads® blog

Posted in indexing, Investing
September 2014
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