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Are You Using the Right Yardstick to Measure Investment Performance and Risk?
Last Updated: April 27, 2015
Have you ever put together a fantasy sports team? If you have several fantasy sports teams – let’s say one for football, baseball and another for basketball – you know the measure of success is different for each league. You wouldn’t want to measure performance of the baseball team using football’s statistics – touchdowns, completions, passing yards, rushing yards. In baseball, batting average, RBIs, runs, errors, ERA, home runs are more pertinent measures of the strength or success of the team.
Likewise, for a well-diversified retirement plan line-up, it’s important to use the appropriate measures of performance for the respective index. For example, if we invest in small, growth stocks based in areas outside of the United States, it would not be useful to compare performance against large, U.S. based companies. The small, foreign companies are expected to grow at faster rates as their countries’ younger, emerging economies develop; utilizing advances in technology and experience changes in demographics and wealth. On the other hand, more mature, developed economies such as the U.S. tend to grow at lower rates but not experience the same level of volatility or variability in price swings.
So how do you determine what “measuring stick” or index to use?
First, let’s define what is an index. An index is a group of stocks chosen to represent a certain segment of the market – i.e. large vs. small, domestic vs. foreign, growth vs. value for the equities. For the bond market, you would consider whether or not the bonds are high quality (investment grade) or low quality (junk), issued by private companies (corporate debt) or by government institutions or agencies (treasuries, GNMAs, sovereign credit).
For an index to be meaningful, it has to be an accurate representation of the group of securities you want to compare AND it has to be universally accepted by the investment community and peers as a valid and appropriate index. However, two different indexes can meet these criteria and still use different techniques to calculate returns, additions and deletions.
Let’s compare two popular domestic indexes that are both used when discussing the performance of stocks of large U.S. companies – the Dow Jones Industrial Average and the S&P 500. The Dow Jones Industrial Average is an index that contains the 30 largest U.S. corporations. It is one of the first indexes developed by Charles Dow and Edward Jones, originally comprised of 18 companies.
The S&P 500 is a much broader representation that includes the 500 largest U.S. corporations. So, at a very basic level the S&P appears to provide a more comprehensive picture of the U.S. business landscape given the larger number of companies included in the index.
The other major difference between these two indexes is how the value of the index is computed and what measure of a company the index uses to determine its weight (and influence) in the index. The Dow Jones uses the stock’s price. So, if Acme Anvil Co. (AAC) is trading at $100 per share and Zenith Rockets Co. (ZRC) is trading at $10 per share, AAC will have more influence on the price of the index.
The S&P 500, by contrast takes the price of the stock and multiplies it by the number of shares outstanding. So if AAC has 10 shares outstanding, their market cap is $100 x 10 shares = $1000. If ZRC has 1000 shares outstanding, their market cap is $10 x 1000 shares =$10,000. So on a market cap basis, ZRC has more influence than AAC in the S&P 500.
Indexes can also be compiled based on more general traits such as market capitalization (i.e. large cap, small cap), market sector (i.e. technology, energy), style (growth, value), or a combination of the aforementioned traits, such as, a small cap technology index. They seem straight forward; however, the compilation of such indexes can be quite diverse. To understand this better, let’s explore the differences in three mid-cap value indexes; the Russell, Standard and Poors (S&P), and Center for Research in Security Prices (CRSP).
The Russell Mid-Cap index is the smallest 800 securities in the Russell 1000 index. From there attributes are assigned to securities based on value and growth metrics. Securities are then assigned as either value or growth with some being assigned to both. The Russell Mid-Cap Value index (a subset of the Russell Mid-Cap index) generally holds 600 securities with a mean market cap of $9.6 billion.
In contrast to the Russell Mid-Cap index, the CRSP US Mid-Cap Value index generally holds a more compact portfolio of 200 securities. With a mean market cap of $10.1 billion it has the greatest exposure to large cap securities. Therefore, depending on an investor’s portfolio it might not be the best representative of the selected asset class.
In comparison to the CRSP index, the S&P 400 Value index has the smallest mean market cap of roughly $3.8 billion. Smaller capitalization companies are riskier because there is a greater chance of bankruptcy or discontinuing business. Because of the added risk, investors demand a premium for holding these securities. Therefore, we expect the S&P 400 index not only to have the highest risk, but also the highest return over a full market cycle. However, that is not necessarily the case. The Russell, CRSP, and S&P indexes have had 3-year annualized returns of 19.57%, 20.17%, and 18.34%, respectfully.
The point is, not all indexes are created equal and may impact your investment line-up exposure and returns. But using the right measuring stick or index to measure investment performance and risk can help you maintain a strong, diversified investment line-up that performs well and mitigates your investment risk.
Need help determining which index to use? Contact Pension Consultants’ Investment Team or call 417-889-4918 to learn more.
