Vanguard small cap funds FAQ

=FAQ on Vanguard Small Cap Funds=

This page attempts to address the most frequent questions regarding Vanguard small cap funds.

How many small cap funds does Vanguard provide?
Vanguard has eleven non-institutional small cap funds:
 * Explorer (active small growth) VEXPX
 * Explorer Admiral shares VEXRX
 * Explorer Value (active small value) VEVFX
 * Strategic Small-Cap Equity (active small blend) VSTCX
 * Small cap growth index VISGX
 * Small cap index NAESX
 * Small cap index Admiral shares VSMRX
 * Small cap value index VISVX
 * Tax-managed small cap index VTMSX
 * FTSE All World ex. U.S. Small Cap (International) Index VSFVX
 * International Explorer (active international small growth) VINEX

What percentage of the total stock market do small caps represent?
About 10% small caps would equal the weighting of the total stock market. International small cap would also require about 10% to complete the FTSE All World ex. U. S. index. Note that whereas U. S. Total stock market contains the market weight in small caps, neither the FTSE Index or Total International index include small caps.

Are small cap funds necessary in my portfolio?
If you desire to hold small cap allocations at market capitalization weightings you can hold a US Total Market Index fund and meet your allocation desires without adding a small cap fund. However, if your employer provided retirement plan provides you with an S&P 500 index fund and no other low cost options you may wish to add a small cap fund in your taxable account or personal retirement plan in order to mirror the market. See Approximating Total Stock Market for guidance.

You would also want to add a small cap fund to your portfolio if you desire to "tilt"  your portfolio asset allocation towards higher small cap and/or value weightings than those provided by market cap weighting.

Since Vanguard's international index funds do not allocate market weights to international small cap funds, you might want to add a small cap international index fund to your portfolio. (See Vanguard FTSE All-World ex-US Small-Cap Index Fund which suggests holding this fund in a 1:9 ratio with the FTSE-All-World ex-US index for those seeking market cap weighting. The combination of these two funds is sensible as the funds track exactly complementary indexes. Additional international small cap options are available at International Small-Cap).

What does "tilting" to small mean and how much should I tilt?
Financial experts often recommend that investors should use index mutual funds to invest in entire markets, or, invest in funds that approximate the total market.

In general, the stock market is composed of 3 levels of market capitalization and 3  styles, resulting in a 3 x 3 "style" box. As defined in the style box for VTSMX, the majority of the US Market (the Total Stock Market or "TSM") is held in large caps. Therefore, this fund (representing the US Market, or the "Market") is defined as a "cap weighted" market. The intent is that these distribution percentages, by definition, accurately represent the composition of the entire market. Gain and loss over time represents the movement of the market as a whole.

If you invest $1.00 in a total market index fund, each stock receives the same amount of your dollar in proportion to it's cap weight. The largest stock gets 100 times the amount of a company 100th it's size. Therefore, no company gets more or less than that determined by it's market capitalization.

Tilting is defined as any deviation (change) from the Total Stock Market distribution percentages as previously defined. Tilting is a good term because it implies you adjust within reason and don't go overboard with extreme weighting to small.

Historically, there have been periods of time where value stocks and small stocks have provided higher returns than large blend and growth stocks (example: the early 1990's bull market). Based on past performance, some investors choose to add additional value and small stocks to their portfolio. The most efficient way to do this is to overweight small value stocks. Overweight means increasing your holdings to more than is naturally in the market profile.

The Small cap styles represent 9% (3 + 3 + 3) of the total market. Tilting to Small means overweighting your portfolio to hold more than 9% of Small cap stocks.

Considerations

 * In some cases, tilting can allow the investor to add more fixed-income securities (bonds) to the total portfolio.
 * Over the long term, investing in a tilted portfolio may not be productive as the market is expected to Revert to the Mean.
 * The investor's behavior during bear and bull markets can influence results.
 * Although small and value stocks have higher expected returns than growth stocks, investors should recognize that the record of realized returns does not assure a similar pattern in the future. The timing and magnitude of the value premium will always be uncertain, i.e. past performance does not predict future performance.

How tax-efficient are the small cap funds?
Actively managed small cap funds are not very tax efficient, as the distribution history of the Vanguard Explorer fund and the  Vanguard International Explorer Fund demonstrate. Active funds tend to distribute hefty capital gains distributions. Vanguard small cap index funds are currently very tax efficient as a result of the following three factors:
 * 1) The benchmarking of the funds to MSCI and FTSE indexes which utilize transition bands between size and valuation metrics. These bands tend to reduce the turnover of stocks as they migrate across indexes, which helps reduce taxable gain realization.
 * 2) The accumulation of realized loss carryforwards from the 2000-2002 and 2008 bear markets. These carryforwards can be applied to offset future realized gains in the funds through fiscal year 2017. Active small cap funds tend to realize gains at a much quicker rate that do index funds. This tendency results in active funds depleting loss carryforwards much faster than index funds.
 * 3) The ETF share classes of Vanguard index funds, through the institutional creation and redemption process of ETF shares, serve to enhance the funds' tax efficiency by gradually removing low basis stock from the fund portfolios and by stabilizing the funds' level of loss carryforwards.

Under current law, qualified dividends are taxed at lower capital gains tax rates. The qualified dividends a small cap index fund passes on to shareholders is reduced by the holding periods of a fund's purchases and sales of stocks and by the extent of a fund's holding of REITS, whose dividends are unqualified. Vanguard's most tax efficient small cap fund is the Tax-Managed Small-Cap Fund, which has never distributed a capital gain distribution in its ten year history and which has provided 100% qualified dividends to its shareholders since the provision was enacted. Since the 2004 advent of ETF share classes in the index funds, none have distributed a capital gains distribution: