Own Vanguard ETFs/Mutual Funds? Check Your Holdings Closely

It has been nearly impossible to escape the bear market

You perhaps have noticed that since the start of the current bear market for stocks on Jan. 3rd of this year, almost all Vanguard stock ETF offerings (and mutual funds) are in negative territory, most deeply so. So, would there have been any advantage in holding any other fund other than the one that holds stocks of all market capitalizations (e.g. Large-, Mid-, and Small-Cap and styles (e.g. Growth, Value or Blend), namely the Vanguard Total Stock Market ETF (VTI) or VTSAX? This is another way of asking whether holding one or more additional funds would have provided significant of diversification away from falling stocks.

Funds that rise and fall together

If you click on this link, you will see the correlations between VTI and all the remaining 61 ETFs. In every case, the correlations are positive, implying that every fund has a track record of moving in the same direction as VTI, whether domestic or foreign, large or small, or merely investing in a given sector of the market. (As a reminder, correlation measures the degree of relationship between two factors, such as performance between two funds over a given period. In most cases, these correlations are quite high, usually falling between .80 and into the mid to high .90’s. The maximum positive correlation is +1.00 while the minimum is .00.) This means that when one fund is up, so is the other. Such very high correlations do not show a high degree of diversification once one owns VTI by investing in additional Vanguard ETFs, with the highest correlations tending to show the least diversification.

As an example, let’s focus on the advantage of owning the Vanguard Growth ETF (VUG), in addition to VTI. The correlation between the two funds is +.96. This might seem to suggest that the returns of the two funds are nearly always nearly equal, but this assumption would not always be correct.

As I’ve said above, correlation measures the tendency of two funds to move together so that if one fund has done extremely well or poorly, the other fund should typically do quite well or poorly too, although the degree of magnitude may differ. This has indeed been the case over the last 12 months; while VUG has fallen approximately 23%, VTI has fallen a more moderate 14% (data through 9-15). However, in 2020, when VUG climbed a little over 40%, VTI also had a very good year, while only climbing about half as much. But over the longer term, the returns of the two funds are much closer to equal.

Overlapping holdings

Here is a fact that you may not be aware of:

VTI holds over 4000 stocks. But because its biggest holdings are based on the stocks with the biggest market capitalizations, the six biggest positions, in order of the stocks it owns, are

1. Apple Inc. (AAPL)
2. Microsoft Corp. (MSFT)
3. Amazon.com Inc. (AMZN)
4. Tesla Inc. (TSLA)
5. Alphabet Inc. (GOOGL)
6. Alphabet Inc. (GOOG)

Scattered among the remaining of the top 20 holdings are many familiar companies. Altogether, the top 20 holdings make about a third of the entire fund’s assets. Once we get to the smaller capitalization holdings, (say, from about 175th in size down) each makes up no more than .10% of the portfolio and most considerably less. So, it is easy to see that the top six assets in the portfolio fund have a strong influence on the fund’s results.

But the growth-oriented VUG, while holding only about 250 stocks, has the same six stocks as VTI has, in the exact same order in size, comprising more than 40% of the portfolio. You would expect this fund to be considerably different than a fund such as VTI which aims to invest in the total stock market. It is no wonder that the two funds would have a high correlation, with the size of the correlation rather highly correlated to the performance of these six technology stocks.

Conclusion and Suggested Action

What this all adds up to is this: If you own both VTI and VUG, you are owning many of the same stocks twice. This suggests that you are much less diversified than you might think. Although over the last 12 months, it paid to own both funds because one lost less in VTI, it would seem that if both funds continue to hold so much in common, there would be little advantage to holding both.

The correlation between two funds is an important indicator of their degree of diversification from one another. But as we have seen above, while two funds may have a high correlation, they may still provide some degree of diversification when one of the funds moves up and down paralleling the up and down movement of the other although not necessarily with the same degree of magnitude.

Since most Vanguard stock ETFs (and funds) have a high correlation with each other, most have been unable to provide much diversification in the current bear market. What can investors do? As the above list of correlations between VTI and every other Vanguard ETF, investors should be looking for those funds with the lowest correlation to the overall market.

While the link reveals that it is impossible to find two stock Vanguard stock funds with a zero or even a negative correlation, which if such existed, would provide the best diversification possible, the two funds currently with the lowest correlation are Utilities and Energy. Even some choices with correlations in the .70s and 80s would be the best choices to diversify a portfolio of Vanguard stock funds. You can find the correlation between any two funds, including non-Vanguard funds (or even individual stocks) by going to the following link. Of course, most bond funds usually provide a good degree of diversification from stocks, but that is not the subject of this article.