Vanguard small cap funds FAQ

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 addresses the most Frequently Asked Questions (FAQ) regarding Vanguard small cap funds.

How many small cap funds does Vanguard provide?
Vanguard currently provides seventeen non-institutional small cap funds:

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 the Vanguard U. S. Total stock market and Total International index funds contain the market weight in small caps, the FTSE Index, holding large and mid cap stocks, does not.

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.

Currently, the Vanguard Total International index fund is the only Vanguard international index fund allocating market weights to international small cap stocks. If you hold any of the other Vanguard international index 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 a sensible choice for investors seeking total market weighting as the funds track exactly complementary indexes. Additional international small cap options are available at International small cap).

What are the expected returns of the different funds?
According to 30 year return estimates from William Bernstein and Rick Ferri small cap stocks can be expected to provide the following returns:

Vanguard index funds can be expected to provide the market return, less expenses and transaction costs. Vanguard active funds offer the hope of providing excess returns to the market, at the risk of providing less than market returns.

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. Other portfolio theorists advise holding portfolios that tilt toward small and value stocks. 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 its cap weight. The largest stock gets 100 times the amount of a company 100th its size. Therefore, no company gets more or less than that determined by its market capitalization.

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.

Historically, value stocks and small stocks have provided higher returns than large blend and growth stocks (in both domestic and foreign markets). The theoretical basis posited for these higher returns states that small stocks and value stocks are riskier than large and growth stocks, and that the higher returns compensate investors for higher risk. Based on theory and past performance, some investors choose to add additional value and small stocks to their portfolios. Many investors who tilt employ what is termed a 4x25 allocation consisting of equal parts of 25% large blend; 25% large value; 25% small blend; and 25% small value. Tilters employ blend indexes for growth stock exposure in response to the long term performance of small cap growth stocks. Other tilters, valuing greater portfolio simplicity, overweight small value stocks by adding a small value fund to the market portfolio (see John Bogle on tilting in the sidebox quote). Overweight means increasing your holdings to more than is naturally in the market profile.

Considerations

 * In some cases (higher expected returns), tilting can allow the investor to add more fixed-income securities (bonds) and less equity to the total portfolio.
 * The investor's behavior during bear and bull markets can influence results. An investor who tilts must be able to hold to the allocation during periods when the tilted equity portfolio under performs the market portfolio. An investor should also resist the temptation to engage in "performance chasing", that is buying or selling a size or style tilt based on recent performance.
 * Tilted portfolios require long holding periods as the market, value, and size factor returns often rotate over time.
 * 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 size and value premiums will always be uncertain, i.e. past performance does not predict future performance.

My company plan does not have a small cap fund, how can I add one?
If you would like to invest in a small cap fund outside of your company plan you can place the investment in either your personal retirement plan (Traditional IRA or Roth IRA) or in your taxable account. (For guidance on asset location considerations refer to Principles of tax-efficient fund placement).

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 CRSP 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 than 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. Small cap value index funds provide higher dividend payouts than do small growth or small blend indexes. 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:

The Vanguard FTSE All-World ex-US Small-Cap Index Fund like a majority of international small cap funds and ETFs has distributed a small capital gain early in its history. The fund's passive management approach and ETF share class structure should result in improved tax efficiency over the long term. The fund also qualifies for the foreign tax credit for taxable investors.