Q: Are you aware that Vanguard is changing the methodology for the Vanguard Total Stock Market Index? With the majority of my retirement...
Q: Are you aware that Vanguard is changing the methodology for the Vanguard Total Stock Market Index?
With the majority of my retirement money in this fund, I am concerned. After trying to get more information from Vanguard’s Web site, I remain unsure if it is indeed a better methodology.
Worse, Vanguard is warning shareholders that fund expenses will temporarily increase during the transition. What do you think?
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— J.R., Houston
A: Don’t lose any sleep over this change. Between now and the year’s end, the Total Stock Market Index fund will shift from the Wilshire 5000 index to the MSCI U.S. Broad Market Index.
While the Wilshire 5000 index tracks 100 percent of the U.S. equity market, the MSCI U.S. Broad Market Index covers 99.5 percent, eliminating the smallest and least-liquid stocks.
You can get an idea of the concentration in the U.S. stock market by considering that one component of the MSCI U.S. Broad Market Index is the Investable Market 2500 index, which represents 98 percent of all domestic-market value.
The index change will incorporate an operational change that index investors will celebrate once its benefits are understood.
Traditional stock indexes are constructed by taking the number of shares outstanding, regardless of ownership. That figure was multiplied by the price of the shares to get the total market capitalization. Then the value of the stock as a percentage of the entire index was calculated.
If the total market capitalization of the stock amounted to 1 percent of the index, that’s how much of the fund it accounted for.
For most stocks, this isn’t a problem because their shares are widely distributed.
There are a number of stocks, however, in which the founding owners continue to own a substantial portion of the shares — think Bill Gates.
This reduces the “free float,” the number of shares that trade in the market.
The net result is that market capitalization-based indexes can put excessive buying pressure on stocks with limited share float, causing regular overpricing of the shares.
The same additional pressure on share prices also means that the bid/ask spread tends to widen, increasing the transaction costs of the fund. As a consequence, moving to free-float indexing will help index funds track their indexes with fewer errors and reduce costs.
Another thing to remember: Index funds operate at a small fraction of the costs incurred by most managed funds. The temporary increase in expenses you see will be minuscule.
Questions about personal finance and investments may be sent to Scott Burns at The Dallas Morning News, P.O. Box 655237, Dallas, TX 75265; by fax at 214-977-8776; or by e-mail at email@example.com. Questions of general interest will be answered in future columns.