Jonathan Kitchen
After writing about passive investing in the US market via the Vanguard Total Stock Market ETF (VTI), this follow-up examines one of the closest alternatives. The iShares Core S&P Total U.S. Stock Market ETF (NYSEARCA:ITOT).
Given that I introduced the logic behind passive investing in both my last article on VTI and the previous one on the S&P 500, I will keep it rather short at this point. Readers who are more interested find more details in the aforementioned articles. In a nutshell, passive investing means to hold the market portfolio. That is the value-weighted collection of all available assets.
For this article, we will simplify this theoretical ideal to 1) only equities, and 2) only the US market. I repeat myself, but it is important to understand that just investing in a cap-weighted US market index is not passive. It is passive within the US, but from a global perspective, it remains an active bet on one (historically very successful!) country. From an even more global perspective, it is also an active bet on just one asset class (equities). I hope you see the logic. Academic finance gives us a theoretical ideal (truly holding everything out there) and all funds and ETFs are just more or less good proxies to approach this.
With that in mind, let’s see how ITOT and VTI differ with respect to passive exposure to the US equity market.
ITOT vs. VTI – The (Misleading) Long-Term
In the first chart, I plot cumulative total returns (i.e. all dividends are hypothetically reinvested) of both ETFs over the longest common period. VTI is the older of the two (inception on 05/24/2001), so the chart begins at January 20, 2004, the inception date of ITOT.
Surprisingly, there is a notable performance gap of about 20%-points between the two ETFs and VTI was clearly better over this 19 year period (8.94% p.a. vs. 8.71% for VTI and ITOT, respectively). I would argue that an annual return difference of more than 20 basis points for two products that are supposed to measure the same thing deserves some more analysis. So let’s see where it comes from.
If we go to the website of the two funds (and are nerdy enough to read all footnotes), we will find that the ETFs changed quite a bit over time. Specifically, both ETFs tracked different indices over different periods in the past. For ITOT:
On December 18, 2015, ITOT began to track the S&P Total Market Index. Prior to December 18, 2015, the fund tracked the S&P Composite 1500.
Source: ITOT Website, Key Facts, Benchmark Index, accessed 01/11/2023.
For VTI, we have even three indices since inception of the fund in 2001:
Dow Jones U.S. Total Stock Market Index (formerly known as the Dow Jones Wilshire 5000 Index) through April 22, 2005; MSCI US Broad Market Index through June 2, 2013; and CRSP US Total Market Index thereafter.
Source: VTI Website, Footnote 1, accessed 01/11/2023.
So overall, the two ETFs tracked five different indices over the last 19 years. That’s unfortunately a bit messy and the historical performance in the chart above is thus quite useless to decide between ITOT and VTI going forward. As we all know, past performance doesn’t guarantee future results. This is especially true when the methodology changes.
Let me try to disentangle this. Until December 18, 2015, ITOT tracked the S&P 1500 Index. According to its website, this index covers about 90% of the US market capitalization and “[…] is designed for investors seeking to replicate the performance of the U.S. equity market […]”. More specifically, the S&P 1500 is a market-cap weighted combination of the S&P 500 (Large Caps), the S&P 400 (Mid Caps), and the S&P 600 (Small Caps).
You know what’s coming, right? 90% of the US market capitalization and “only” 1500 out of roughly 4000 US stocks is not truly passive. In fact, the index has even more active filters. For example, cumulative profits of constituents must be positive over the last four quarters (I worked with this index in my master thesis and discussed such criteria in section 3.1). Also note that the composition of the S&P 1500 is not systematic. A committee ultimately decides about constituents at each rebalancing date. They obviously base their decision on data and follow certain rules, but in the end, it can be somewhat discretionary. The bottom line: With the S&P 1500, ITOT tracked an imperfect proxy for the true passive US market portfolio until December 18, 2015.
To see how this compares to VTI’s MSCI US Broad Market Index, I isolated the total returns for ITOT and VTI between January 20, 2004 and June 2, 2013 in the next chart. Please note that this is still somewhat imprecise because VTI changed its index in April 2005. However, this shouldn’t matter too much for the general pattern.
The chart clearly shows that when ITOT tracked the S&P 1500 Index, it clearly underperformed VTI and thereby the broader market indices. This already explains some part of the long-term performance gap from above. Until December 2015, ITOT simply tracked the theoretically and also performance-wise worse proxy for the US market. But how does the picture change after ITOT switched to the S&P Total Market Index (S&P TMI)? Looking again at the website of the index, this one seems much better. It “[…] is designed to track the broad equity market, including large-, mid-, small-, and micro-cap stocks.” According to the latest Factsheet, the index had more than 4200 constituents and is thus closer to the true market portfolio than the S&P 1500. At least theoretically, this should improve ITOT. The next chart shows how it turned out with respect to performance.
The performance gap is now considerably smaller. The period is obviously also shorter, but you find similar results when looking at average annual returns. Between 2004 and 2015, ITOT underperformed VTI by about 33 basis points per year whereas the number decreases to just 4 basis points between 2015 and 2023. In my opinion, this is now really negligible.
To sum up. Just comparing the long-term performance of the two ETFs is somewhat misleading because the two tracked quite different indices over their lifetime. The details are unfortunately a bit messy and difficult to disentangle. Nevertheless, I hopefully managed to show that the performance gap narrowed when both ETFs tracked comparable total market indices since December 2015. As we are probably more interested in the future than in history, I will conclude this article with a brief comparison of the indices that the two ETFs are currently tracking and what this means for the performance going forward.
ITOT vs. VTI – The Road Ahead
Since 2013, VTI tracks the CRSP U.S. Total Market Index which captures most of the investable US market and currently consists of more than 4,000 stocks. As this article is primarily about ITOT, I refer readers who want to learn more about the CRSP index to my last article. The important point, however, is that CRSP (a data provider, affiliated with the University of Chicago) delivers a scientifically robust proxy for the US equity market that is probably also cheaper than most other indices (more about the impact of index fees here).
As mentioned earlier, ITOT switched on December 18, 2015 from the S&P 1500 to the S&P TMI. Looking at the S&P Index Methodology, this was a good decision for the purpose of managing a truly passive US portfolio. The S&P TMI also covers more than 4000 stocks and, more importantly, has not the same active eligibility criteria like the S&P 1500. This index just includes all US stocks that meet certain regulatory requirements and are liquid enough to be considered investable. In my opinion, this shift was therefore beneficial for ITOT investors and iShares deserves credit for doing it.
The following chart shows the performance of the two indices over the last years. Note that contrary to the other charts, this one just shows price returns because YCharts apparently has no total return data for the S&P TMI available.
Despite very similar methodology and the same purpose (approximating the US market portfolio), there remains a performance gap of about 3.4%-points. Unfortunately, I don’t have detailed data to tell you where it exactly comes from. My best guess is that there are some minor methodological details that compound over time.
What does this mean for the future of ITOT and VTI? Well, the indices slightly differ and so will probably the performance of the ETFs. However, both of them now track plausible and theoretically founded proxies for the US market portfolio. That said, VTI was historically (even after controlling for different underlying indices) the better alternative. And we find the same picture when we just look at the performance of the underlying indices: CRSP was slightly better than S&P. At this point, I have to disclose some confirmation bias. In my last article, I argued in favor of VTI because Vanguard and CRSP are both built around the mission to offer scientifically rigor and cheap passive investing to the average investor. It is nice that the performance comparison to ITOT supports this argument, but there is obviously no guarantee that the pattern will continue in the future! But historically, Vanguard and CRSP delivered better results than iShares (BlackRock) and S&P.
Finally something I also mentioned several times in this little series on passive investing (VOO, VTI, and now ITOT): the things I am writing here about are really in the “nasty detail” category. Index funds on the US market are mostly commodities and there is probably no reason to switch from ITOT to VTI for a few (going forward, uncertain!) basis points more if you feel comfortable with iShares. Instead, the main purpose of my articles is to show that even simple things like index funds involve a lot of nasty details. The most important takeaway in this respect, is to pay close attention to the underlying index and don’t just compare ETFs by their historical performance (which is generally a bad idea for almost all investments…).
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