Everyone knows the New York Stock Exchange. And its rival, Nasdaq.

But there is a mutual fund that invests in stocks based on a relatively unknown market index that has grown so large it might be considered a third stock market unto itself.

That fund is the $1.3 trillion (yes, trillion, including all share classes) Vanguard Total Stock Market...

Everyone knows the New York Stock Exchange. And its rival, Nasdaq.

But there is a mutual fund that invests in stocks based on a relatively unknown market index that has grown so large it might be considered a third stock market unto itself.

That fund is the $1.3 trillion (yes, trillion, including all share classes) Vanguard Total Stock Market Index Fund (VTSAX) and its exchange-traded-fund shares. The fund, from Vanguard Group, now accounts for 10% of all assets in U.S. stock mutual funds and ETFs in the market, according to Morningstar Inc. No other mutual fund or ETF comes close to it in asset size. The next largest is an $821 billion Vanguard S&P 500 index fund.

The paradox is that this biggest beast among funds is tied to the most unassuming of stock indexes—the CRSP U.S. Total Market Index, developed at the University of Chicago’s Booth School of Business.

While many investors may not be familiar with CRSP, the influence of the index and the Vanguard fund is felt minute to minute on Wall Street. Traders say they sometimes check the Vanguard fund’s ETF version, with the symbol VTI, to get a better idea of what is happening in the market overall, since it effectively covers more stocks than any of the three major indexes—the Dow Jones Industrial Average, S&P 500 index and Nasdaq Composite.

“When the stock market is open, VTI gives you a better picture of what it’s doing than anything else,” says Rick Ferri, an investment adviser in Georgetown, Texas. The CRSP, he adds, “drives this gigantic mutual fund, and most of the general public doesn’t even know that CRSP exists.”

Just what is the CRSP index? It was designed by the Center for Research in Security Prices, or CRSP, a subsidiary of the University of Chicago’s business school until it became a university-owned limited liability company last year. One reason the CRSP index is relatively unknown among the general public is that it was built at Vanguard’s behest only a decade ago from a monthly research tool for academics into its current form as an investible index.

Because the CRSP index consists of more than 4,000 stocks—including everything from tiny (or microcap) stocks to blue-chip giants—it shows how the entire market is doing. By comparison, the Dow Jones Industrial Average tracks just 30 big-name stocks, the S&P 500 follows the performance of 500 large companies and the Nasdaq consists of more than 3,500 stocks, many of them smaller.

Minimizing the impact

To be added to the CRSP index, a company must operate a for-profit U.S. business, have a stock-market value of at least $15 million, and at least 12.5% of its shares outstanding must trade publicly, among other criteria. CRSP adds and drops stocks every quarter, and reflects some big initial public offerings and secondary offerings in a matter of days.

Additions to the CRSP index—and thus, to the Vanguard fund—can rock parts of the market. When 164 stocks were added to the index in mid-September, their combined trading volume that week doubled from the average of the prior four weeks, according to FactSet. And their prices jumped 3.6 percentage points more than comparable microcap stocks in the same five-week period.

Elisabeth Kashner, director of global fund analytics at FactSet, says some “market impact and front running” are inevitable when there is such a sizable buyer.

CRSP Chief Executive David Barclay

acknowledges that some market participants may seek “a way to get in front of” trading related to index changes. The 100-plus subscribers to CRSP’s index include big Wall Street dealers, hedge funds and market makers.

He says CRSP has taken steps to reduce the market impact of trading by funds like Vanguard. When it adds new stocks in the quarterly rebalancing, for example, it adds them over a five-day period rather than all at once.

CRSP tracks dozens of corporate actions daily, from dividends and stock sales to acquisitions or IPOs, to ensure the index weights companies in proportion to their shares outstanding and its database reflects their dividend rates. On Nov. 11, the index weights for Avenue Therapeutics Inc., Chinook Therapeutics Inc. and SiTime Corp. increased by a combined 0.00164% to reflect recent stock sales, and Arhaus Inc. and NerdWallet Inc. were added at 0.00067% of the index to reflect their IPOs a week earlier. (By comparison, Apple Inc. was 4.87% of the index.)

Vanguard’s trading floor in Malvern, Pa., in 2019. The influence of Vanguard’s giant Total Market fund is felt minute by minute on Wall Street.

Photo: Ryan Collerd for The Wall Street Journal

Sauter’s brainchild

CRSP began life in 1960 as a $300,000 research project backed by Wall Street’s then-largest brokerage firm, Merrill Lynch, Pierce, Fenner & Smith Inc., which wanted evidence that stocks were a good investment.

The index’s development with Vanguard’s backing was the brainchild of a University of Chicago business graduate, Gus Sauter, who became Vanguard’s head of stock index funds in 1987.

Vanguard’s original index fund, launched in 1976, had used the S&P 500, which then included only about 75% of the market. In 1992, Vanguard launched a total U.S. market fund to give investors the opportunity to invest in the entire market. The fund originally followed the Wilshire 5000 Total Market Index. Vanguard in 2005 moved it to Morgan Stanley Capital International, now known as MSCI Inc., partly because Wilshire didn’t adjust stock-index weightings based on shares publicly traded, known as a stock’s “float.” That risked forcing the Vanguard fund to buy up too much of some companies’ shares outstanding, distorting the price.

Not long after, Mr. Sauter asked Ted Snyder, then the dean of the University of Chicago business school, if CRSP could be cranked up from a research resource to a daily investible index, promising that Vanguard would advance the development expenses. Near the end of a five-year ramp-up, Vanguard announced the fund’s index would shift to CRSP in 2013.

Mr. Sauter says cost-cutting was a “very significant” reason Vanguard shifted to CRSP. Vanguard currently pays CRSP about $20 million annually to license its indexes. But he adds that CRSP’s long experience in stock-market research and its database made Vanguard confident that CRSP could provide a quality index.

Vanguard’s current equity index chief, Rodney Comegys, said Mr. Sauter’s approach with CRSP gave the Vanguard fund a long-term low-cost structure.

Tesla boost

Last year, CRSP and the Vanguard fund scored a win over its biggest U.S.-fund rival, S&P Dow Jones Indices, when Tesla Inc. stock rocketed up more than 700%. Tesla wasn’t part of the S&P 500 for most of the year because S&P requires new additions to be profitable, while CRSP doesn’t.

Partly because Tesla was in the CRSP index, the index’s 2020 return of 20.99% (and that of the Vanguard fund) beat the S&P 500 by 2.59 percentage points, the widest margin of outperformance by either index since 2013, according to Bull and Bear Profits, an investment newsletter. (Dow Jones & Co., publisher of The Wall Street Journal, no longer has an ownership stake in S&P Dow Jones Indices, though Journal editors are on the committee that picks the stocks in the Dow Jones Industrial Average.)

The Vanguard fund’s assets have mushroomed by 10 times since 2009, according to Morningstar. Its current size equals roughly 2.8% of the entire U.S. stock market.

In 2019, after the death of Jack Bogle, founder and retired CEO of Vanguard Group, the NYSE paid tribute on its video screens.

Photo: brendan mcdermid/Reuters

A future in futures?

CRSP aims to expand its business by creating new indexes from its database of 11,300 securities and attracting new users in both investment management and academia. In September it launched six ESG indexes based on environmental, social and governance factors with proxy adviser Institutional Shareholder Services.

“We want to increase the ability for our research database to be used more broadly,” said Mr. Barclay.

On a Wednesday in mid-November at CRSP’s offices in a nondescript office building in downtown Chicago, CRSP managing director Eric Frait —a veteran Chicago options executive—watched as Bloomberg Television displayed a series of six boxes with pre-opening futures data based on the Dow, S&P, Nasdaq and even the Toronto Stock Exchange. CRSP, he says, might rate a TV data box, too, if it had futures.

CRSP does, in fact, hope to develop a market for futures—tied to the total market index, Mr. Frait says.

Mr. Smith, a former financial reporter for The Wall Street Journal, is a writer in New York. He can be reached at reports@wsj.com.