ITOT: Diversification Doesn’t Always Lead To Outperforming Returns

Recently, my attention was drawn to an ad promoting iShares Total Stock Market ETF (NYSEARCA:ITOT) (prospectus). The ad highlighted the diverse nature of the index into the total stock market, along with the fund’s reasonable 0.03% expense ratio. I’m not an avid investor of exchange traded funds, but if I’m going to participate in a broad market fund, it will need to outperform some of the more popular index exchange traded funds.

On its face, ITOT has a great blend of diversification and low expense ratio. When compared to popular iShares and SPDR index fund ETFs, ITOT has the most holdings at 2,826 companies, even more than the Russell 3000 comparative ETF (IWV). ITOT also has the lowest expense ratio of the group at 3 basis points, with the SPDR S&P 500 ETF (SPY) the next lowest at 9 basis points.

Where ITOT is very similar to other index ETFs is in the fund’s top holdings. Like many of the others in the peer group, ITOT’s top ten holdings consist of mega tech companies like Apple (AAPL), Microsoft (MSFT), and Meta (META), along with other large companies like Tesla (TSLA), Berkshire Hathaway (BRK.A) (BRK.B), and Exxon Mobil (XOM). The top 10 holdings consist of 26% of the fund. Overall, the fund is heaviest on technology (27%) with the next two sectors (healthcare and financials) unable to eclipse the top sector combined. The top three sectors account for over 50% of the fund holdings.

With the low expense ratio and massive number of holdings, it’s important to compare the fund’s performance against the other index ETFs, both overall and at certain periods of time. So far this year, ITOT’s performance has mirrored the Russell 3000 ETF but has returned 33 basis points less than the S&P 500 ETF, which is not enough to cover the discounted expense ratio.

What about a longer-duration comparison? Over the last five years, ITOT has underperformed both the Russell 3000 ETF and the S&P 500 ETF. In fact, SPY has outperformed ITOT by more than 600 basis points. I thought this may have been related to the volatility caused by the pandemic during March 2020, but when looking at the first quarter of 2020, ITOT’s underperformance is only 123 basis points lower compared to SPY.

Each of these ETFs has been around for close to two decades or more. Where ITOT seems to have done better is in the 2009 recovery. While ITOT underperformed the Dow Jones ETF from 2007 to 2009 and matched the performance of SPY, ITOT outperformed its peers in the rally from March to December 2009.

While ITOT outperformed its peers during the recovery in 2009, the fund has underperformed other index fund ETFs since then. The added diversification of more than 2,300 companies over the S&P 500 appears to have no impact on returns. Additionally, the fund is not buffered from market downsides as demonstrated by its performance in both 2007 to 2009 and during the first quarter of 2020. In this case, diversification beyond the S&P 500 does not equate to better returns, even with the lower expense ratio.