Ariel Investments’ market commentary for July 31, 2014.

Our May commentary addressed U.S. stock market performance from January to May. As you may recall, returns had been up and down, large and mid caps had trounced small caps, and value had beaten growth. While the returns of Ariel Fund and Ariel Appreciation Fund were quite similar, the disparity between benchmarks made Ariel Fund look solid and Ariel Appreciation Fund appear lethargic. This commentary will focus more attention on assessing performance generally and on the Russell Midcap Value Index in particular.

Dissecting investment results can be tricky. First and foremost—and this is no secret—strong absolute returns sometimes mask poor relative returns, while low absolute returns can actually be solid in a given market environment. That is, a +10% gain is not astounding in the context of a market that is up more than +32%, as the market was in 2013. By contrast, a –10% loss would have been stellar for an equity portfolio in 2008, when the S&P 500 plummeted –37%.

Even relative returns, however, can be confounding. Portfolios typically compare themselves to specific benchmark indexes, but such indexes themselves can run hot and cold against the broader market and against active managers in the same niche. For instance, examine the following performance table from the midpoint of 2014:

Ariel Investments

People generally assume a benchmark should be average and thereby fall in the middle of a category group, but that is not always the case. As a matter of fact, the following chart shows where the Russell Midcap Value Index would land in Morningstar’s Mid-Cap Blend and Mid-Cap Value categories:

Ariel Investments Hypothetical Russell Midcap

A relevant index landing in the top half or even the top quartile of a mutual fund category would not be mind-blowing, but regularly achieving top-decile performance signals a hot index. Indeed, the Russell Midcap Value Index lately looks hot against its Russell index siblings as well. Below is a broad selection of other Russell indexes—the value, core and growth versions of large, mid, smid, and small indexes.

Ariel Investments indexes

In summary, the Russell Midcap Value Index beats its Russell peers in both the first and second quarters of 2014, and it also ranks number one out of twelve for the 1-, 3- and 5-year periods. (To pile it on, it was number one over the 10-year period as well, falling to number two over the 15-year mark.)

Finally, we want to note: the Russell Midcap Value Index has done this before. We used rolling five-year returns to see whether the index had long stretches of large outperformance versus the funds it should most closely parallel. We compared the Russell Midcap Value Index’s five-year returns to the Morningstar Mid-Cap Value category average as far back as we could. Similarly, we assessed the Russell 2000 Value Index against the Morningstar Small Value category average. While the small-cap index is fairly balanced against small value funds, the Russell Midcap Value has serially crushed the funds most like it. For instance, the Russell 2000 Value’s most remarkable stretch versus small value funds was a seven-month run, from August 1995 through February 1996, wherein its five-year returns topped the category’s returns by an annualized average of 350 basis points per period. The Russell Midcap Value’s streaks make that one look meager. Over an eleven-month period, from mid-1995 through mid-1996, it trounced the Morningstar Mid-Cap Value category by an average of 375 basis points per period. Then, for nearly four years, from late 2004 through late 2008, the Russell Midcap Value Index’s five-year returns topped the Morningstar Mid-Cap Value category’s returns for 46 straight months, by an annual average of nearly 350 basis points per year.

As we have said before, fully explaining this seemingly anomalous performance is no easy feat. The Russell Midcap Value Index has a hefty collection of REITs, which tend to have clusters of good returns of late, and it also features strong doses of utilities and energy stocks, which can strongly correlate with the REITs at times to give a boost.

H/T Dataroma

See full Ariel Investments: July 31 Commentary in PDF format here.