SPY - ITOT: Here's What You Sacrifice When You Buy The Total Stock Market

2023-07-10 21:14:45 ET

Summary

• ITOT offers low-cost exposure to the entire U.S. stock market. Fees are just 0.03% per year, and the ETF has over $44 billion in assets under management.
• Long-term performance relative to S&P 500 ETFs like SPY is competitive. However, ITOT lagged behind in 2021-2022 and is on pace to do the same in 2023.
• One likely reason is quality. ITOT holds approximately 15% of companies by weight that are not in SPY, and they weigh significantly on the portfolio's Profitability Score.
• Unfortunately, the profitability sacrifice is not made up elsewhere. ITOT offers very similar diversification by industry, estimated sales and earnings growth, and valuation.
• As an alternative, investors should separate ITOT into three large-, mid-, and small-cap ETFs. This article highlights several ETFs that have better track records than plain-vanilla funds and superior Profitability Scores.

Investment Thesis

The iShares Core S&P Total U.S. Stock Market ETF ( ITOT ) has delivered nearly an identical return as the SPDR S&P 500 ETF ( SPY ) since its January 2004 launch. However, it's not the route I recommend, primarily because holding 2700+ extra securities drive the fund's quality down without offering any meaningful benefits on diversification, growth, and valuation. There's a reason ITOT hasn't outperformed SPY since 2020, and based on my fundamental analysis, I don't expect this will change moving forward.

ITOT Overview

Strategy Discussion

As its name implies, ITOT owns nearly the entire U.S. stock market, subject to certain liquidity constraints. According to S&P Dow Jones Indices, the S&P 500 Total Market Index launched on March 27, 2006, and has 4,191 constituents with market capitalizations between 720K and $3.05T. Selections are float-market-cap-weighted with quarterly rebalancings every March, June, September, and December. ITOT's expense ratio is just 0.03%, and the fund has $44.25 billion in net assets. It's a go-to ETF for passive investors wanting exposure to the broad U.S. equity market.

While the Index has 4,191 constituents, ITOT has 3,291. However, don't concern yourself with these seemingly significant differences. Because of the Index's weighting scheme, they're primarily micro-cap stocks with an immaterial impact. Even the difference between ITOT and SPY is slight. The additional 2,791 micro-, small-, and mid-cap stocks combine to total less than 15% and are spread evenly across sectors. Let's look at that next.

Sector Exposures and Top Ten Holdings

Sector exposures for ITOT, SPY, and the Vanguard Total Stock Market ETF ( VTI ) are listed below. The most significant difference with SPY is that ITOT has 1.68% less allocation to Technology and 1.39% more exposure to Industrials. VTI is also similar and features the same 0.03% expense ratio.

ITOT's top 10 holdings are listed below. They're identical to SPY, but Apple ( AAPL ) and Microsoft ( MSFT ) are underweight by 1.19% and 1.10%, which accounts for the Technology exposure differences from above.

ITOT has 348 more Industrials stocks that account for its 1.39% additional exposure compared to SPY, the most notable being Uber Technologies ( UBER ) at a 0.20% weighting. UBER is not profitable, so it doesn't qualify for SPY. Other examples are Workday ( WDAY ), Snowflake ( SNOW ), and Marvell Technology, Inc. ( MRVL ).

Performance

Though ITOT launched in January 2004, ITOT's Index launched only at the end of March 2006. Therefore, that's where the performance chart below begins. As you can see, ITOT slightly lagged behind VTI and SPY by 0.08% and 0.17% per year. As is customary when including smaller stocks, ITOT and VTI were more volatile than SPY.

Even though the long-term results are similar, SPY outperformed ITOT by 3.07% and 1.29% in 2021-2022 and is up by 0.61% YTD in 2023. The periodic returns table highlights this outperformance: SPY is up nearly 1% annually over the last five years, emphasizing how well mega-cap stocks have performed.

ITOT Analysis

The following table highlights selected fundamental metrics for ITOT's top 25 industries, totaling 63.25% of the fund. SPY's is 68.64%, so owning the entire stock market doesn't help as much as you might expect, at least from a diversification perspective.

Instead, the benefits come in the form of slightly higher estimated sales and earnings per share growth rates. Most is linked to the overweighted securities mentioned earlier. Uber Technologies, Airbnb ( ABNB ), Snowflake, The Trade Desk ( TTD ), and CrowdStrike Holdings ( CRWD ) are all examples of companies with 25%+ sales growth estimates.

Still, the impact is relatively small, as is the valuation discount these smaller, more speculative companies offer. ITOT trades at 26.79x forward earnings and 23.22x trailing cash flow, just 0.25 and 0.11 points less than SPY. Where might the offset be? The answer is quality. ITOT's Profitability Score is 9.03/10, which I calculated by weighting and normalizing Seeking Alpha Profitability Grades on a 10-point scale. Meanwhile, SPY is much stronger at 9.45/10. For greater context, consider that the profitability score for the 15% of stocks in ITOT but not SPY is just 6.31/10.

Passive investors are better off managing their portfolio's small- and mid-cap sections with dedicated ETFs instead. The reason is that plain-vanilla funds in these segments have inferior track records, and that's what an investment in ITOT includes. For example, the WisdomTree U.S. MidCap Earnings Fund ETF ( EZM ) and the Invesco Zacks Mid-Cap ETF ( CZA ) are two higher-quality mid-cap funds that outperformed the plain-vanilla iShares Core S&P MidCap ETF ( IJH ) over the last 16 years.

The small-cap segment is the most exciting place where higher-fee factor-based funds are beneficial. For example, the Pacer US Small Cap Cash Cows 100 ETF ( CALF ), the Invesco Russell 2000 Dynamic Multifactor ETF ( OMFS ), and the Invesco S&P SmallCap Quality ETF ( XSHQ ) have all outperformed the plain-vanilla iShares Core S&P Small-Cap ETF ( IJR ).

CALF, OMFS, and XSHQ currently have Profitability Scores of 7.90/10, 6.73/10, and 7.54/10, respectively. In contrast, IJR's is relatively low at 6.24/10. The takeaway is that you don't need to sacrifice quality for diversification. You have a better chance at success if you're willing to separate ITOT into three ETFs tracking the large-, mid-, and small-cap segments.

Investment Recommendation

ITOT has slightly underperformed SPY since March 2006 and is on track to lag for the third consecutive year. The primary reason is lower quality. Consider that the 15% of stocks in ITOT but not SPY significantly drag down the portfolio's Profitability Score and don't offer any meaningful benefits on diversification, growth, or valuation. Therefore, it's better to own SPY.

For those wanting to own the entire stock market, understand that plain-vanilla funds like ITOT are not optimal. Factor-based investing works better in the small- and mid-cap segments, so you should be willing to pay a little more in fees for a higher-quality fund likely to outperform. This article offered some suggestions, and if you would like additional on others not mentioned, please feel free to comment below. Thank you for reading.

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