Value Investing

Do Market-Cap Differences Translate Into Performance Variations?

U.S. equity benchmarks are more alike than different. Still, those distinctions can lead to meaningful performance differences, especially in the short run. Here are some of the ways the major index providers approach the markets.

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There is no shortage of ETFs to choose from among U.S. equity funds. While tactics can vary, it’s reasonable to say that the starting point for many clients’ equity portfolios—the basic ingredients of flour and water, if you will—is market-cap-weighted building blocks, such as large-, mid-, and small-cap index funds.

Although many market-cap-weighted U.S. stock ETFs seem similar, there are more nuances than you might expect. The ingredients are largely the same, but the recipes can be different. The question is: Which differences matter and to what degree? Let’s explore.

According to Bloomberg and Morningstar data, about 225 ETFs currently track a market-cap weighted, non-leveraged US equity benchmark, with a total of approximately $1.5 trillion in assets under management – the most of any ETF category. These ETFs track benchmarks from providers such as FTSE Russell, S&P Dow Jones Indices, and CRSP.

Importantly, a large-cap benchmark from S&P Dow Jones Indices is different in many ways from an ostensibly similar large-cap benchmark from FTSE Russell, CRSP, and others. These differences derive from the different methodologies the benchmark providers employ to select and categorize stocks and result in potentially meaningful differences in performance. Evaluating such differences is key to the analytic process of selecting an ETF.

Market-cap differences

Over time, the major benchmark providers have coalesced around generally accepted best practices with fairly minor methodological differences, such as turnover management and growth/value style definitions. However, a remaining major point of differentiation is the definition of break points in the market-cap spectrum used to delineate size. For example, let’s compare the S&P 500, Russell 1000, and CRSP US Large Cap Indexes. All are legitimately defined as large-cap indexes. However, the Russell 1000 includes twice the number of stocks and covers about 92% of the market capitalization relative to the S&P 500’s coverage of about 82% of the market capitalization. CRSP, a provider of benchmarks for Vanguard ETFs, delineates size break points slightly differently, by holding steady the percentage of capitalization coverage and allowing the number of securities in each benchmark to change. For instance, the CRSP large cap index will always cover 85% of the market capitalization, which will be made up of a variable number of stocks (598 at year-end 2016).

Note: In this case, CRSP’s methodology accounts for the fact that the number of stocks in the market changes over time. There are currently about 3,600 investable stocks; two decades ago the number was more like 8,000. By defining the proportion of the market considered large, mid, and small by capitalization coverage, CRSP argues that its indexes better accommodate the market’s inevitable evolution.

Market-Cap Differences

The differences in market-cap coverage are illustrated in the figure above.

By Rich Powers of Vanguard, read the full article here.