Investors beware: Not all indexes are the same
Reprinted courtesy of MarketWatch.com
Published: Oct. 29, 2017
To read the original article click here
More investors — wisely, in my judgment — are using index funds and exchange-traded funds to hold their stocks and bonds.
Many others are using indexes as standards by which to judge actively managed funds and even individual stock picks.
But I’ve just come upon some new research that underscores how much difference there can be between indexes that on the surface look like the same thing.
In fact, the performance of both growth-oriented U.S. equity indexes and value indexes can be strikingly different, depending on which index provider you choose to use.
Fortunately, this is hardly a problem with indexes that track the S&P 500 index SPX, -1.03% . That index is composed at any one time of about 500 large-cap U.S. stocks, and it’s easy to find the list.
An ETF or index fund that tracks the S&P 500 can’t stray very far from those specific stocks, and the differences between their returns most likely come from fees and expenses.
But indexes that track other asset classes can tell a different story. They can have quite different returns, not because of expenses or fees (indexes have none of those), but because of how they are built.
In general, smaller companies tend to outperform larger ones. And those with lower price/book ratios (indicating deeper value discounts) tend to outperform companies with higher P/B ratios.
Accordingly, when you compare indexes that track the same asset class, the most important variables are the average size (market capitalization) of companies they track (smaller is usually better) and the average price/book ratio of those companies (lower is usually better).
I use the qualifier “usually” because over the long haul, smaller companies have outperformed larger ones and stocks priced at deeper discounts (low price/book ratios) outperform stocks that are priced higher relative to their book value.
But there are market cycles when larger is more advantageous and cycles when growth stocks outperform value stocks. Therefore, while blanket statements about performance may be useful in the long term, they can lead to a lot of disappointment in the short term.
Consider the case of three indexes that track small-cap value stocks. The following figures are from the past 19 years, 1998 through 2016.
•The Morningstar U.S. Small Value Index US:JKL has an average market cap of $2.6 billion and an average ratio of 1.34.
•The Russell 2000 Small Value Index VTWV, -1.08% has an average market cap of $1.5 billion and an average P/B ratio of 1.31.
•The S&P Small Cap 600 U.S. Value Index VIOV, -1.36% has an average market cap of $1.4 billion and an average P/B ratio of 1.5.
The compound average growth rates of these three indexes are 10.06% for Morningstar, 8.66% for Russell, and 9.39% for S&P.
Some of these numbers are to be found in a table I have extracted from a long article published earlier this year at FinancialPlanning.com.
The difference between the highest return (Morningstar) and the lowest (Russell) is 1.4 percentage points a year.
As I have written in the past, if you can improve your long-term return by even 0.5%, this can make an eventual difference of millions of dollars.
So a difference of nearly three times that, between two indexes with respectable pedigrees, is HUGE.
Why then is the Morningstar index, built with significantly larger companies, more productive, especially in a period when smaller companies generally outperformed larger ones?
One answer is that Morningstar isn’t required to build its indexes exactly the same way that other companies do.
For one example, Morningstar may require — and in fact requires — companies to be profitable to qualify for its value indexes.
While some indexes may include every stock that falls within size and price-to-book ratios, Morningstar (and other index makers as well) can increase the likely performance of its indexes by excluding companies that lose money instead making it.
In street language, this “profitability factor” is designed to eliminate some of the most “doggy dogs” among value companies and increase the quality of the indexes.
As I mentioned earlier, the market often has periods when large-cap stocks outperform small-cap ones; and oftentimes, growth stocks outperform value stocks.
The upshot is: Index investing is not rocket science. Just because an index has a label of small-cap value or large-cap growth, that doesn’t make it identical (or even very close) to other indexes that claim to represent the same asset class.
In plain terms, if you build an index, you can choose how you’re going to do it.
For investors, the bad news is that you have to look beyond the titles of indexes, mutual funds, and ETFs. That’s sort of like looking at the ingredients label on food you buy.
The good news is that you don’t have to look this far under the hood. These are the combinations of index funds and ETFs that in my opinion are most likely to produce favorable returns over the long haul.
If you need to build an ETF portfolio at Schwab SCHW, -0.63%, Fidelity, Vanguard, or TD Ameritrade US:AMTD, you’ll find my recommendations there.
If instead you’re looking for mutual fund recommendations, you’ll find them here and here.
If, on the other hand, you’re a die-hard do-it-yourselfer and convinced you can do better, then I hope you will take the message to heart about choosing your indexes with great care.
You can learn more on this topic in my recent podcast on the topic of growth vs. value.
Richard Buck contributed to this article.
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