ACWI - VT: As Passive As Practically Possible

Summary

• The Vanguard Total World Stock ETF is one of the leading ETFs to invest truly passively in global stock markets.
• Passive investing means holding the market portfolio. Applied to equities, this is the market-cap weighted portfolio of all available stocks in the world. By definition, this goes beyond the US.
• Since 2008, the US market has a tracking error of 6.6% compared to VT. The active share currently stands at 41% which makes a pure-US portfolio a quite active strategy.
• Historically, active bets on the US were well rewarded. But it's unclear if this pattern continues. The case for passive investing and global diversification is therefore as strong as ever.
• VT tracks the FTSE Global All Cap Index and holds 9,473 stocks from 49 countries. With just 0.07% TER, it is thus a very efficient instrument for global passive investors.

After several articles about passive investing in the US stock market (see here for VOO , here for VTI , and here for ITOT ), it's now time to go international and move closer to the academic idea of the market portfolio. For this purpose, I will start with the Vanguard Total World Stock ETF ( VT ). Similar to US-only funds, there are of course many other alternatives and I may cover some of those in future articles.

Before we start, let me briefly summarize the idea of passive investing to get everyone on the same page. Passive investing emerged from a large body of academic research and is nowadays an important part of the investing tool-kit. Essentially, passive investing means holding the market portfolio. This is the theoretical portfolio which includes all available assets weighted by their most recent market value. Obviously, this is quite difficult to do in practice. However, you can apply the idea of passive investing to every asset class and even within asset-classes to different geographies and regions.

Applied to equities, passive investing simply means holding all available stocks weighted by the underlying companies' market capitalization. That's it, everything that deviates from this benchmark is some form of active management. I also mentioned this last time when I showed that VTI is a very good instrument for being passive within the US market. From a global perspective, however, it is still an active bet on just one country (more on that below).

So much as a brief summary. If you want more details, feel free to check the respective section in my previous article on VTI or have a look at my website .

True Passive vs. US-Only

Let's assume we start with a portfolio that only consists of VTI. Given the definition above, we already know that this is not truly passive because there are no international stocks in there. But how active is this bet on the US from a global perspective? I will use two common measures to answer this question, tracking error and active share.

Tracking error is a widely-used risk measure to quantify how much a portfolio deviates from a benchmark. Mathematically, it is the standard deviation of active returns (portfolio return minus benchmark return) over a defined period. The higher the tracking error, the more active the portfolio and vice versa. In our case, the active portfolio is our isolated bet on the US [VTI] and the benchmark is our truly passive global portfolio [VT].

I downloaded prices of VTI and VT for the longest common period from June 26, 2008 to January 27, 2023 via Microsoft Excel's Stock datatype. Over this period, the annualized active share of VTI with respect to VT stands at 6.6% . To put this into perspective, traditional active mutual funds typically come with tracking errors of 5-10%. So although you intend to be passive with VTI, the isolated bet on the US still makes it a quite active strategy from a global perspective. Of course, this is nothing dramatically new and fully in line with expectations, but I still find the size of this number quite remarkable.

Active share is also a measure to determine the activeness of a strategy, but in contrast to tracking error, it is based on holdings not performance. Think of it as something like the total deviation of position weights between an active strategy and its benchmark. Mathematically, you compare the weights of each position, take the sum of absolute deviations, and divide this number by two. The higher the active share, the stronger deviates the portfolio from its benchmark and vice versa.

Given that I don't have easy access to all holdings of VT and VTI, I did a somewhat simplified calculation of active share. As we know, VTI is 100% US equities. The global VT, in contrast, only holds 59% US equities and 41% international. This means our pure-US portfolio overweights the US by 41%-points with respect to the true passive global benchmark. Given that I simplified the portfolio structure to just two positions (US and international), the active share also stands at 41% in this case. Interpreting active share strongly depends on the chosen benchmark but as a general rule of thumb, anything up to 20% is typically considered "benchmark hugging" or "closet indexing". With 41%, our pure-US strategy is therefore again quite active.

To sum up: no matter how you measure it, you run an active strategy if you just invest in the US. With respect to a global benchmark, you historically had a tracking error that is comparable to typical mutual funds and left out 41% of the world's market capitalization.

Now let's go to the more interesting point and see how the funds performed over their longest common period since June 2008.

In case someone didn't recognize it over the last years (hopefully it's clear that this is irony), the chart shows how the US [VTI] massively outperformed international equity markets (VEU), and thus also the global benchmark [VT]. What does this mean? Well, it means that the active bet on the US was heavily rewarded over the last years. From a global perspective, you accepted a tracking error of 6.6% and got a compounded outperformance of almost 4%-points per year since 2008. Going with 100% US was therefore very smart active management and I don't want to talk this down.

However, and this is the theme of most of my articles, I think it is important to understand what we are doing. I am completely fine with people who actively say "I believe for reason XYZ that the US is the best place to invest and therefore go 100% into VTI." But if you put all your money in the US market back in 2008 and mistakenly thought that you are truly passive, I think you were just lucky (sorry!) and maybe should check if this active bet really fits your beliefs.

Now, this was all history. All of us recognized that the US massively outperformed and the obvious (and much more interesting) question is whether this will continue. There are some plausible reasons why the US might be a superior place for equity investors: the probably freest markets in the world, more innovative and successful public companies, the most developed financial system, a large domestic market... But on the other hand, most of the outperformance over the last 30 years came from continuous multiple expansion (see this piece from Cliff Asness for more). Also note that we all suffer to some degree from recency-bias and there were times when Europe, Emerging Markets, and even Japan outperformed the US. Quite hard to imagine right now...

Long story short, I think it is very hard (if not impossible) to predict whether this impressive outperformance of the US equity market continues. My best guess is that the difference will at least narrow. Despite the painful 2022, the US market still comes with higher multiples than the rest of the world and in my opinion, it is dangerous to assume that things will always get even more expensive...

As a consequence, the argument for true passive investing (or at least some global diversification) is as strong as ever. In fact, you can also flip around the chart above and regard it as a warning sign what may happen when you actively bet on the wrong geography!

In the next section, I will therefore show how VT effectively implements a truly passive portfolio which will always give you the global risk premium without any danger of betting on the wrong country.

Going Truly Passive with VT

As mentioned before, passive investing with respect to equities just means to hold all available stocks weighted by their market capitalization. What sounds quite simple is actually not so easy to implement without running into too much costs. But this is the reason why companies like Vanguard exist.

The Vanguard Total World Stock ETF [VT] tracks the FTSE Global All Cap Index which is indeed very close to the theoretical idea of the global market portfolio.

The FTSE Global All Cap Index is a market-capitalization weighted index representing the performance of large, mid and small cap companies in Developed and Emerging markets. The index is derived from the FTSE Global Equity Index Series (GEIS), which captures 98% of the world's investable market capitalization.

Source: FTSE Website , accessed January 28, 2023.

In practice, this translates into a market-cap weighted portfolio of 9,437 stocks from almost 50 developing and emerging countries as of December 30, 2022. In my opinion, this is sufficiently close to "all available stocks" and the index is thus a reasonable choice for a "Total World" fund. It is also worth mentioning that except for some investability criteria, the index does not apply any additional filters (remember that the S&P 500, for example, only includes stocks of profitable firms). The index also delivered very similar returns like offerings from well-known competitors (MSCI, S&P, CRSP).

Vanguard physically replicates this index and currently holds with 9,473 even slightly more stocks. As we know it from Vanguard, they do this for an extremely low fee of just 0.07%. This is of course more than the 0.03% for VTI, but given that it is more costly to trade multiple international markets, I believe this is still very fair. With respect to tracking error, Vanguard also does an exceptional job and the annualized performance of the fund is currently just 4 basis points lower than that of the index.

As you know from my previous articles, I am a bit of a Vanguard-Fan because this company has done so much good for the average investor. But even adjusting for that, I believe that VT is just a very efficient and scientifically founded instrument to capture the global equity risk premium.

Conclusion

This article is primarily about the Vanguard Total World Stock ETF [VT] but given the outperformance of the US market over the last years, an article about a global fund can hardly avoid the question of US vs. International. As I mentioned, I think this is a really hard one and I don't know a definite answer.

To be honest, I could imagine that the strong outperformance of the US could be actually harmful for some investors going forward. Why? Because it somehow casts a shadow on the results of rigor empirical research which clearly tells us that most investors are probably better off with a globally diversified, truly passive portfolio. But even though it is the rationally right thing to do, I understand that it is psychologically very difficult to underperform for >15 years with VT while many peers make a lot of money with their US bets.

I am not in the position to tell anyone to no longer overweight the US and this is not the purpose of this article. Instead, I hopefully visualized that what some people mistakenly regard as passive is actually quite active if you take a broader perspective. It is perfectly fine to bet on the country, factor, sector, stock or whatever else you expect to outperform. But if you find yourself to hold a pure-US portfolio as a result of inertia without a clear opinion why it should outperform, I think it is better to go global and invest truly passive. For that purpose, VT is an outstanding instrument.

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