How AI Distorts the Returns of Vanguard’s Largest ETFs: VOO vs. VTI

The recent returns of VOO and VTI appear to contradict conventional wisdom that small and mid-sized stocks outperform large-cap issues over the long term.

By Mitchell MartinForbes team

Two of the five largest U.S. exchange-traded funds are low-cost siblings of the Vanguard family that have not performed as expected over the past five years. THE Vanguard S&P 500 ETF (known by its ticker VOO) sports $473.4 billion of large-cap stocks that make up the Standard & Poor’s 500 Index, and the more complex Vanguard Total Stock Market ETF (VTI) includes more than 3,700 issues additional assets that provide exposure to small and medium-sized U.S. businesses and weigh in at $406.9 billion in assets. Both funds have lowest annual expense ratios of 0.03%.

All of VOO’s assets and approximately 87% of VTI’s holdings (in dollars) are S&P 500 stocks., according to data of the ETF Research Centre. This means that VTI is somewhat less exposed to the S&P 500, particularly the more valuable members of that index. Jeff DeMaso, editor-in-chief of Vanguard Independent Advisor, calculates that around 31% of VOO’s portfolio is represented by stock market darling Nvidia, alongside Microsoft, Apple, Amazon, Alphabet and Tesla. VTI’s exposure is only 27%.

Alongside its thinner holdings in the S&P 500, VTI holds positions – each representing about 0.3% of its assets – in smaller companies like homebuilder Toll Brothers, retailer Dick’s Sporting Goods and Robinhood Markets, the discount brokerage.

THE RIVAL BROTHERS OF VANGUARD

Behemoths VOO and VTI have similar portfolios, but VOO has more large-cap technologies driving the market.

In theory, this diversity should be a good thing. Large-cap company returns have dragged those of small companies on the stock market since the 1920s, with the largest companies earning around 10% compared to 12% for their smaller counterparts. There are several possible explanations for the outperformance of small stocks, but the basic concept is that they are inherently riskier and therefore investors demand higher long-term returns for holding them, as authors Roger G. Ibbotson and James P. Harrington in the 2021 work. edition of Stocks, Bonds, Notes and Inflation. “It is unclear,” they added, “whether this is due to size itself or other factors closely related or correlated with size.”

However, in the competition between Vanguard funds, the addition of small stocks in VTI does not appear to have led to better performance over the past decade than large caps alone – at least at first glance. Fact sheets on both investments show VOO beat VTI for each of the latest 1-year, 3-year, 5-year, and 10-year periods through March 31, although both funds saw significant gains in all of those periods. The disparity this calendar year is particularly large, with VOO to come back 15.3% based on net asset value until June 21 against. 13.5% for VTI. Much of this outperformance occurred in the current quarter.

When comparing fund returns for specific time periods, the start and end dates can have a significant effect on the results. To give a fairer picture, investors can consult sliding returns, which take into account each year’s annual results over a set period of time rather than simply measuring from start date to finish. Since VOO only started in 2010, Forbes asked Vanguard to provide 10-year rolling data whose early years were based on portfolios of similar mutual funds rather than the ETF itself .

BIGGER LOOKS BETTER

Historical performance of the Vanguard S&P 500 ETF (VOO) and the Vanguard Total Stock Market ETF (VTI)

Seen this way, over the 10 years through 2023, each fund had five times the best return and all gains were consecutive streaks. VTI prevailed from 2014 to 2018 and VOO performed best from 2019 to 2023. Measured another way, investors who invested equal amounts in both funds once a year over the past 10 calendar years n would have only had an advance of around 3% in VOO. , and he only took the lead in 2021.

The reason why VOO did better? America’s biggest tech companies are in tears.

“Large-cap stocks, primarily growth-oriented technology stocks, posted exceptional returns and paced the market, helping VOO outperform VTI,” Mo’ath Almahasneh, associate research analyst at the fund Morningstar specialist, tells Forbes by email. He notes that VTI’s previous outperformance dates back to the early 2000s. Indeed, Vanguard’s rolling data shows that VTI streak starting in 2005 and spanning 14 consecutive years before VOO took over.

VOO’s recent strength has come from technological advances made during the Covid-19 pandemic, when lockdowns and working from home encouraged greater use of online services. As this advantage diminished, it was replaced by an enthusiastic embrace of artificial intelligence (AI). “The key theme for returns today is clearly anything that stands to benefit from the latest developments in artificial intelligence,” says Eric Compton, Morningstar’s director of equity research for the technology sector.

The star child is Nvidiawhose chips developed for computer graphics have found new uses in AI, which explains how the company became the first stake in VOO and why the slightest exposure of VTI harms the fund.

CONTINENTAL RETURNS CHANGE THE PICTURE

On a 10-year rolling basis, VOO’s outperformance is not as impressive

One effect of this reduced allocation to large-cap tech is that Morningstar grants VTI a three-star rating, compared to VOO’s best five-star review. But this rating is retrospective, explains Almahasneh, and is due to the limited performance that reflects the distribution of allocations. It underlines the forward-looking orientation of the company Medal system, which classifies both ETFs as gold, meaning they are expected to add the most value among similar funds over a period of at least five years.

The question for investors considering the two ETFs — or any other similar choice between a broad-market fund and one with more exposure to big tech companies — is how sustainable large-cap outperformance can be.

“A few factors could slow the group’s high-flying returns,” Morningstar’s Compton told Forbes via email. “The first element is simply the current valuations, which already include solid growth for the main beneficiaries of AI. For example, we believe that many of the obvious beneficiaries of hardware AI are fully valued, and in some cases overvalued. This could lead to reduced gains, or even decline, in the high-flying AI sector. But probably not today or tomorrow, Compton adds.

“In the short term, we do not expect this to happen as many key growth drivers, such as GPU sales for Nvidia, appear to be de-risked in the coming quarters given current order books, “but if the outlook starts to show unexpected deceleration, be careful,” he says. NvidiaGraphics processing units, a type of computer chip, are widely used to power hardware for artificial intelligence as well as for Bitcoin mining.

On the other hand, technological innovation is one of the reasons why the American economy continues to grow. faster than those of other developed countries.

“To the extent that future technological innovation continues to favor leaders and consolidated markets,” Compton says, “large companies can be expected to maintain their dominance.”

This would be a plus for VOO, but it requires a lot of upside to maintain outperformance based on the technology components of the S&P 500. Given the modest yield difference between the two funds and the fact that VOO trades at 26 .1 times earnings at the end of May versus 25.1 for VTI, one would either have to have great confidence in the ability of the large-cap technology sector to continue to dominate the market, or have considerable contempt for the idea that small stocks will outperform over the long term.

Vanguard itself doesn’t like to comment on the market, but spokesperson Michael Nolan provides a macroeconomic outlook that would give VTI at least a slight edge: “Over the next 10 years, Vanguard expects that the average annual return of large-cap US stocks is between 3.1% and 5.1%, and US small-cap stocks are between 4.3% and 6.3%.

For DeMaso of Independent Vanguard Advisor, VTI has a slight edge. “If I were choosing one today, I would lean towards Total Stock Market,” he told Forbes via email, “since the tech giants can’t keep the market going forever. In other words, smaller stocks will ultimately outperform. Don’t ask me when!

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