Does the Total Stock Market fund include small caps, yes? Do those small caps have much of an affect on the performance of that fund vs. VFINX? Not really b/c the TSM fund only includes a very small % of small caps. When small outperforms large, TSM should outperform VFINX by around 1-3% in that year, depending on how much small outperforms large. And likewise, when large outperforms small, VFINX should outperform TSM by 1-3% in that years, depending on how much small outperforms large.
Also remember that the majority of the small cap premium was in the micro caps, which TSM includes very few of. So TSM doesn't get that much of a boost from the small caps it includes. When people like Ibbotson, Bernstein, and others talk about small caps, they mean the smallest 20% or the smallest 2 deciles by market capitalization, not the Russell 2000 or S&P 600, which include larger stocks as well - what academics would call "mid caps". The definitions of small caps, mid caps, large caps, value, blend, and growth vary depending on whether you talk to M* or academics.
TSM also doesn't rebalance b/w small caps and large caps. It just lets the large, mid, small %'s change as the market capitalizations of each stock changes. For example, when large outperforms small by a lot (like in the 1990's), large caps begin to make up a higher % of the TSM fund. When small does better than large, small caps begin to make up a higher % of the TSM fund.
The reason for the inclusion of small caps is their non-perfect correlation with large caps. Even thought small caps are riskier by themselves, we should only care about by how much their inclusion in our portfolios either increases or decreases our our portfolios' risk. Small caps may or may not outperform large caps in the future [likewise foreign stocks may or may not outperform], but I'd rather include both small caps and large caps and not bet either way.
The advantage of TSM is that it really never has to buy and sell stocks, except when there is a merger or something. So, it should have slighly lower turnover than the S&P 500 fund. Also, let's say that the S&P committee (which chooses the 500 stocks for its large cap index) overlooks a company that turns out to be a steller stock performer. It's very likely that the TSM fund does include that stock.
- Alec