In recent years a type of index fund that buys the "entire" market has become very popular in America, and I suppose eventually the rest of the world is going to catch up and start selling them soon.

The "total market" funds usually follow a very broad index, like the Wilshire 5000 in America, which includes approximately 7000 stocks. The index trackers do not buy all of the stocks however, there is a little bit of management where the manager tries to eliminate some companies to be left with something a little bit more manageable, they buy between 2000 and 3000 stocks on average.

The reason for their popularity is understandable, with such broad portfolios investors hope they will get significant exposure to smaller capitalisation stocks, for more diversification.

Vanguard sells one of these (not available in Australia) and John Bogle talks about them in his book Common Sense on Mutual Funds, recommending them as a great way to diversify. They are popular because they supposedly eliminate the need to rebalance a portfolio because they already contain a good number of small cap and value stocks.

(If you do want to invest in a US total market index fund, TD Waterhouse has one).

There are critics though, and I am one of them, that think perhaps investors are not quite getting what they expect. For a start, the holdings in the index funds are market capitalisation weighted. This sounds sensible of course except when you consider just how much the biggest companies dominate the portfolio. The top one hundred stocks in America, representing just 3% of the number of stocks in the index funds actually account for over 60% of the funds invested in Vanguard's fund.

When you get down to the genuinely small capitalisation stocks there is actually very little money invested in each stock, which is why it probably isn't surprising that over long periods of time the Wilshire 5000 index performs pretty much the same as the big capitalisation growth stock dominated S&P500 index.

Using data provided by The Center for Research in Securities Price, University of Chicago (CRSP) and Eugene Fama and Ken French, "The Cross-section of Expected Stock Returns," The Journal of Finance, June, 1992, from 1964 through to 1998:

CRSP 1-10 "Total Market" index 12.3%
S&P 500 index 12.3%
Fama/French Large Value index 15.1%
CRSP 6-10 Small Co. index 13.2%
Fama/French Small Value index 17.4%

Value stocks outperformed, in particular small capitalisation value stocks, yet they weren't enough to make any significant change in the performance of the total market index compared to the S&P500. When you consider that the total market funds tend to have higher management fees it makes you wonder what exactly the point is.

As I have said in the last few articles, asset allocation is about more than just diversification. When you rebalance a portfolio you take advantage of a contrarian timing bias (sell the winners, buy the losers), which leads to higher performance overall. The art of creating a good portfolio is not about owning everything in market weighted proportions as the total market index does, but in having significant exposure to every asset class and rebalancing the portfolio at an appropriate frequency.

Why should you hold less small cap value stocks just because these make up only a minute proportion of the market as determined by capitalisation? Nobody is forcing you to, so if you want to take advantage of the rebalancing effect you are going to need to have a much larger small cap value exposure in your portfolio than just a couple of percent.

There are index funds available that cater to investors that want to bias their portfolios toward value and small cap stocks compared to a total market index, Dimensional Fund Advisors is one of the best known managers to specialise in these "other" types of index. They are not easy to invest in in Australia because DFA is only a wholesale manager in this country with a $500,000 minimum invest per fund, though there are ways of getting them (a cheap wrap account I use with fees under 0.8%pa has DFA and many other funds) and I use DFA regularly for my own clients.