In "The Lazy (and Wise) Man's Portfolio", I wrote about a nicely diversified portfolio that consists of just a foreign-stock fund and a total stock market index fund. Some readers wanted to know how a fund that owns only a fraction of the stocks in the U.S. market can track it. Here's how these funds do it.

Dear Professor,

I own Vanguard Total Stock Market Index VTSMX, and I just saw in its Morningstar Quicktake that the fund owns 1,800 or so stocks. I don't get it: The fund tracks the Wilshire 5000 index, so why doesn't it own 5,000 stocks? Is my fund cheating?

Michael D.

Your fund is cheating, kind of. When it comes to tracking indexes with lots of small- and micro-cap stocks, such as the Wilshire 5000, index funds will come up short on the total number of holdings. Fidelity Spartan Total Market Index FSTMX and even Wilshire's own Wilshire 5000 Index Portfolio WFIVX also have fewer than half as many holdings as the index. They usually have no choice, because the smallest stocks are too small for the funds.

Simply, a total-market fund would rack up excessive costs trying to build positions in all the smallest stocks. Here's an example: As of January 4, the 5,000th-largest U.S. stock was music-recycler K-Tel International KTEL. Even though millions of TV-watching insomniacs know the K-Tel brand, the company's market capitalization (the total dollar value of all the shares of its stock) is just $64 million. That tiny market cap reflects that the stock isn't widely owned; in fact, only five of the thousands of mutual funds own it. With few owners, such stocks are illiquid, or not traded frequently or in large amounts. Roughly $250,000 worth of K-Tel stock trades each day. That's a lot to you or me (me, at least) but a pittance to a mutual fund. With its $18.1 billion asset base, it would take Vanguard Total Stock Market a month to build a market weighting in K-Tel. At the same time, the fund would have to pay trading costs and would drive up the stock's price because the demand for the stock would exceed the supply.

The trick, reveals Vanguard's index king Gus Sauter, is to mimic the index, not to duplicate it exactly. He and other total-market index-fund managers buy a representative sample of the stocks in the Wilshire 5000. Thus, the fund's 1,800-plus holdings reflect the market capitalization, industry weightings, and dividend yields of the index. Vanguard Total Stock Market's returns have tracked the Wilshire 5000 well. In its seven and a half years of operations, the fund has lagged the index an average of just 30 basis points per year, mostly because of its expense ratio of 20 basis points.

Peter Di Teresa does not own shares in any of the stocks mentioned above.