The AAII Asset Allocation Models provide individual investors guidance on reasonable asset allocations that take into account their time horizon and ability to withstand short-term market volatility. The models incorporate three key building blocks to a successful allocation strategy: stocks, bonds and cash.

To demonstrate the returns and volatility realized by each of the three models (aggressive, moderate and conservative), we use Vanguard mutual funds to track performance. Index funds were purposely selected to minimize expenses and limit the influence of decisions made by active managers. The Vanguard funds chosen are widely available and have generally low investment minimums.

Vanguard is unique in that many of its mutual funds are also available in exchange-traded fund (ETF) share classes. For instance, an investor can use the Vanguard 500 Index Admiral Shares mutual fund (VFIAX) or hold the Vanguard 500 Index ETF (VOO). The choice is a matter of preference and any limitations related to the type of account used.

While we use Vanguard funds to track the portfolios, they are not the only option for those wishing to use the allocation models as a guideline for their own portfolios. In this article, we show alternatives for investors who prefer to use broad index funds in their portfolios.

At a high level, understand that the specific funds available to you will be dictated by the type of account used. Individual investors with a discount broker account (taxable or retirement) have access to all mutual funds and all ETFs on a transaction- and commission-free basis, respectively. On the other hand, workplace retirement accounts like 401(k), 403(b) and 457(b) plans may be tied to a specific fund family. Options may also be more limited in 529 college savings accounts and health savings accounts. In such situations, we suggest first considering the fund that matches each component of the allocation model and has the lowest expense ratio.

Don’t Judge an Index Fund by Its Name

When considering any index fund, pay attention to the index followed. Differences in the index followed will lead to differences in the returns realized by two funds with similar names. You’ll see this as we discuss the various components of asset allocation models.

When in doubt about how an index is constructed or what it is designed to do, search online for the fund’s underlying index or indexes along with the words “fact sheet” or “methodology.”

Domestic Stock Indexes and Funds

Three companies provide the indexes tracked by the biggest large-cap, mid-cap and small-cap index funds.

S&P Dow Jones Indices (S&P DJI) is the index provider most familiar to individual investors. Its domestic indexes include the S&P 500 index, the S&P MidCap 400 index and the S&P SmallCap 600 index. The indexes essentially hold, respectively, 500, 400 or 600 domestic exchange-listed stocks of a set market-capitalization range chosen from the S&P Total Market index. The S&P Composite 1500 index encompasses all 1,500 stocks.

FTSE Russell Indexes owns the Russell 1000 and Russell 2000 indexes. As the names imply, the Russell 1000 encompasses the 1,000 largest U.S. corporations. The Russell 2000 encompasses the next 2,000 largest corporations. The Russell 3000 index encompasses all 3,000 stocks.

The Center for Research in Security Prices (CRSP) is much better known among academics and industry practitioners than individual investors. Its indexes are tracked by several Vanguard funds. The CRSP U.S. Large Cap index tracks companies comprising the top 85% of investable market cap. It included 562 companies as of September 2022. The CRSP U.S. Mid Cap index targets companies ranking in the top 70% to 85% of market cap (350 companies). The CRSP U.S. Small Cap index includes “companies that fall between the bottom 2–15 percent of the investable market capitalization.” Market caps for the nearly 1,500 companies included in this index ranged from a high of $15 billion to a low of $21 million at the end of September 2022.

All of the aforementioned indexes are market-cap weighted. The largest companies in each respective index will have the greatest influence on returns. The smallest companies will have the least impact on performance.

Table 1 provides comparisons of domestic index mutual funds and ETFs in the large-cap, mid-cap and small-cap blend categories.

Download the Excel spreadsheet of this table.

Large-Cap and Mid-Cap Exposure

One advantage of going with a mutual fund or ETF tracking the S&P DJI or CRSP indexes is the ability to tailor large-cap and mid-cap exposure. Separate funds can be bought to get desired weightings, such as 20% large-cap stocks and 20% mid-cap stocks—which is called for by our aggressive investor allocation.

The Russell 1000 includes both large-cap and mid-cap stocks. A single mutual fund or ETF tracking this index can be used to get exposure to both, but you would lose the ability to tailor your weightings to these two categories.

CRSP and S&P DJI offer alternatives to those who prefer the simplicity of owning fewer funds than controlling large- and mid-cap exposure. The CRSP U.S. Total Market index tracks more than 4,000 companies. S&P DJI’s Dow Jones U.S. index has approximately 1,100 companies.

Small-Cap Exposure

While it is possible to get exposure to small-cap stocks with a single fund tracking the Russell 3000 or the CRSP U.S. Total Market, the market-cap-weighting structure does not provide significant enough exposure for investors following the aggressive investor allocation model. Even though the moderate and conservative allocation models have smaller weightings to small caps, we still prefer direct exposure to small-cap stocks.

Within the small-cap arena, the number of stocks in the index determines how extensive the exposure to small-cap stocks is. The S&P SmallCap 600 only provides exposure to the largest small-cap stocks since it is limited to 600 stocks. The Russell 2000 and the CRSP U.S. Small Cap, with its 1,500 stocks, provide exposure to far smaller size companies due to the large number of stocks each index encompasses.

The small-cap effect—the outperformance of small-company stocks relative to large-company stocks—strengthens as company size shrinks. Therefore, more exposure to the smallest companies better exploits the effect. Though Russell and CRSP small-cap indexes provide such exposure, their performance is still heavily influenced by the largest small-cap stocks. There are less widely followed indexes providing exposure to smaller small-cap stocks, which we’ll discuss in a future article.

Foreign Stock Indexes and Funds

Table 2 shows funds in the developed and emerging markets blend categories.

Download the Excel spreadsheet of this table.

Developed Markets Exposure

The most widely followed index for developed markets stocks is the MSCI EAFE index. It tracks large- and mid-cap stocks across 21 different countries in Europe, Australasia and the Far East (but not Canada and the U.S.). Included in this market-cap-weighted index are nearly 800 stocks.

Vanguard uses the FTSE Developed All Cap ex US index for its developed markets mutual fund and ETF. This index encompasses large, mid and small companies in 24 countries across Europe, Australasia and the Far East. It also includes Canada, but not the U.S. This market-cap-weighted index covers more than 4,000 stocks.

Differences in country exposure as well as the number of stocks impact comparative performance between funds following the MSCI or the FTSE index. In both cases, returns will also be affected by fluctuations in the U.S. dollar and regional economic conditions. Vanguard mutual funds following the FTSE index have a slightly higher category risk index than funds following the MSCI index, but the difference is not large enough to be significant.

One consideration when choosing a foreign mutual fund or ETF in addition to getting adequate diversification across countries is whether or not it is hedged against the U.S. dollar. Such hedges help to smooth out fluctuations in the dollar but make the funds more costly and could hurt returns when the U.S. dollar moves in a manner favorable to U.S. investors.

Emerging Markets Exposure

There isn’t the level of commonality in terms of indexes used among emerging markets funds that we see in other equity categories. The emerging markets indexes used by the largest mutual funds and ETFs are the FTSE Emerging Markets All Cap China A Inclusion index and the MSCI Emerging Markets index.

FTSE Emerging Markets All Cap China A Inclusion includes stocks from 24 countries. China, India and Taiwan account for about two-thirds of the overall weighting in the index. MSCI Emerging Markets also covers 24 countries. China, India and Taiwan have an approximate combined weighting of 60% in this index. The Vanguard emerging markets funds following the FTSE index have a long-term edge in terms of performance.

The largest number of options for emerging markets index funds exists among ETFs. Given the wide diversity of indexes, it’s important to look at how each index is weighted. Differences in country exposure as well as any tilts or styles incorporated into an index will impact returns. Pay attention to the inception date as well, since many emerging markets ETFs lack 10-year return histories.

Bond Indexes and Funds

Table 3 compares the largest intermediate-term and short-term bond funds.

Download the Excel spreadsheet of this table.

Taxable bond funds are used to track the AAII Asset Allocation Models, so they are the focus here. Municipal bond funds can be substituted if desired.

The standard index for intermediate-term bonds is the Bloomberg U.S. Aggregate Bond index. Most, but not all, intermediate-term taxable mutual funds and ETFs track it. The index includes Treasuries, government-related and corporate securities, fixed-rate agency mortgage-backed securities, agency asset-backed securities and commercial mortgage-backed securities.

The Bloomberg U.S. 1-5 Year Corporate Bond index tracks U.S. dollar-denominated, investment-grade securities issued by industrial, utility and financial companies with maturities between one and five years. The ICE BofA U.S. Corporate index tracks the performance of investment-grade corporate debt publicly issued in the U.S. domestic market.

Vanguard funds follow float-adjusted versions of the indexes, which generally exclude some U.S. agency bonds held by the Federal Reserve.

Bond indexes are harder to follow than stock indexes because not all bonds are easy to buy and sell quickly. Nonetheless, the expense ratio should generally be the overriding factor when choosing among the funds following a bond index if there are no limitations of choice.

Choosing Index Funds for Your Portfolio

The underlying index tracked by a fund should be a consideration for investors using an index mutual fund or ETF. The indexes covered here are widely followed and provide broad diversification within their respective categories. While there are some differences between funds following peer indexes, the impact on returns for the funds highlighted in this article is small.

When no limitations on choice exist (e.g., fund availability, transaction cost considerations, etc.), opting for the mutual fund or ETF with the lowest expense ratio is a good rule of thumb to follow. This said, a difference of just a few basis points (e.g., an expense ratio of 0.03% versus 0.05%) will have a minimal impact on your wealth.

You may also want to consider how much you want to specifically target each component of the asset allocation models versus your desire to hold fewer funds. A fund tracking a broader index like the CRSP U.S. Total Market may be desirable for an investor looking for simplicity. Investors who wish to directly follow the asset allocation models will be better served by holding individual funds for each category.

Future articles in this series will discuss alternatives for implementing the asset allocation models in your portfolio, including options for incorporating tilt and style preferences. AAII members desiring further options can also find them in our Mutual Fund Guide and in our ETF Guide.

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