All indexes are the same, right?
Last Updated: September 30, 2016
For the past decade or so, index funds have become all the rage from academia, to Middle America, to the corporate boardroom. Index funds are designed to replicate the performance of an underlying index by buying all (or substantially all) the securities in that index. There are dozens of index providers such as S&P, Dow Jones, Morningstar, Russell, CRSP, and MSCI. Index mutual fund companies pick one of these index providers to build their index funds around. However, some investors are surprised to discover that all indexes with the same mandate don’t necessarily perform the same.
Investors generally assume all of these indexes are equally relevant and accurate representations of market performance. For example, if an investor owned a fund focused on U.S.-based, mid-size, value companies, they would probably be concerned if their fund trailed a mid-cap value index by almost 5% year-to-date. How is that possible?!? Shouldn’t the Russell Mid Cap Value index, the S&P Mid Cap Value index and the MSCI Mid Cap Value index all roughly own the same stocks? You might think so, but these very similar sounding indexes can be very different in their component securities and in how they are constructed.
Index providers have several decisions to make when creating their indexes. Typically, their goal is to divide the stock market into sections that have different risk and return characteristics. For example, domestic companies may “zig” when foreign companies “zag”; large companies frequently act differently from small companies; and growth companies act in a different way from value companies. But what is the definition of a large company? Or, what makes some companies growth companies and others value companies? Surely, the definition of domestic vs. foreign is uniform, right?
Domestic vs. Foreign
The first decision index providers are faced with is what makes a domestic company a domestic company. Sometimes it is based on where the company’s physical headquarters building is located. Others base it on what country’s tax regime the actual company is subject to. Or, it can be driven by where the company derives the majority of its revenue. Finally, it could be based on where the exchange is located on which the company chose to list. For example, Alibaba Group (BABA) is a shell company headquartered in the Cayman Islands, that does almost all of its business in China and southeast Asia, while being solely listed on the New York Stock Exchange. Does that make it an American company?
Large vs. Small
All the major index providers agree that the large vs. small definition should be based on market capitalization (rather than by sales, or number of employees, etc.), but how many size groupings and where the cutoffs should be vary dramatically. For example, Morningstar segments the market into five sections Mega, Large, Mid, Small, and Micro capitalization companies. Other providers have only three or four size bands. So what is large? Russell says the 1,000 biggest companies are large. S&P defines it as the 500 largest. CRSP puts the cutoff at 70% of the total market capitalization (approximately 660 companies).
Growth vs. Value
Some of the biggest index differences come from the definition of growth vs. value stocks. Broadly speaking, growth stocks are growing faster than the overall market based on “some set of metrics”, while value stocks are undervalued by the market based on “some set of metrics.” Those metrics are defined by each provider. Some of the growth criteria generally used are trailing and/or projected revenue growth, trailing and/or projected earnings growth, return on equity, and stock price momentum. Value definitions frequently include price/book ratio, price/sales ratio, cash flow/price ratio, and dividend yield. Depending on which metrics are selected and how they are weighted, you can see how one index’s growth stock could be another index’s value stock.
Index providers must also decide how often to rebalance their index, stock weighting methodology, liquidity requirements for stocks to be included, and how index returns are going to be calculated. While you may be able to tell a little bit about an index by its name; there is a lot more that is going on below the surface to make that index what it is. Whether you are a corporate retirement plan sponsor selecting benchmarks or an individual looking for an index fund; indexes matter!
For help selecting the right index, contact Pension Consultants’ Investment Services or RetireAdvisers® or call 417.889.4918. Pension Consultants is ready to assist you with this important decision!
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