All Indexes Are Not Created Equal December 20, 2017 by Bob Kargenian of TABR Capital Management Some Indexes Matter, And Some Don t A little over two years ago, we decided the long term evidence of trying to select actively managed equity funds in comparison to their index peers was too compelling to pass up, and thus we switched virtually all equity exposure in client portfolios to ETFs (exchange traded funds) that represent various indexes and parts of the stock market. Mind you, we are still tactical in deciding how much exposure to have, but this was about WHAT we should own. Today, there are more indexes than stocks, and as you will see below, there is a lot of overlap in many areas (large cap, mid cap). We had to narrow the universe down to a manageable level and eliminate redundancy. So, we went about the process you will see below, essentially comparing the four largest providers of ETF indexes against one another in each category. Those providers are Blackrock, Vanguard and Schwab, but note that Blackrock has its own brand called ishares, which use both the Russell indexes as well as the S&P Indices (Standard & Poor s). As it turned out, Fidelity Investments, the custodian we use for clients, introduced a list of ETF s that advisors could trade on behalf of clients with no commissions. In former days, that might have been a really great incentive, but it is no longer, not when the vast majority of our clients are eligible to trade stocks and ETFs for as little as $4.95 per trade, as long as they are using electronic delivery for their documents. Nevertheless, if you have ETFs in a category that are the best performing AND you can buy or sell them with no commission, why not use them? We went about evaluating the choices by looking at just a few metrics, which included the expense ratio, intermediate and long term performance, and size. The data you will see below is current, and continues to confirm the choices we made in the summer of 2015 in terms of creating our custom matrix. A Little Bit About Composition Before we get into the comparisons of large company indexes and others, it is appropriate to talk about the differences in how some indexes are computed. Most indexes we will be discussing are capweighted, meaning that the stocks with the greatest capitalization have the greatest weight in the index. The most popular of the cap-weighted indexes is the S&P 500, which accounts for about 80% of the Page 1, 2018 Advisor Perspectives, Inc. All rights reserved.
market cap of U.S. stocks. In its case, the top 25 stocks, or 5% of the index, currently account for 32.5% of the index. Currently, the top five companies in the index and their respective weight are Apple (4.05%), Microsoft (2.87%), Amazon (2.07%), Facebook (1.92%) and Johnson & Johnson (1.65%). In contrast, the Dow Jones Industrial Average of 30 stocks is price weighted, so the highest priced stock in the index, Boeing at around 240, today has almost 8 times the weight of Cisco (32) and almost 10 times the weight of General Electric (25). In my view, this is a really dumb way to create an index, but there it is. Finally, there are equal-weighted indexes, where every stock in the index carries an equal weight. A great example is the RSP, an equal-weight version of the S&P 500, where each stock has a weight of 2/10th of 1%. A side note we ve owned this ETF in client accounts for over two years now, simply because it has remained at the top of the monthly rankings that we maintain. Large Company Indexes Below we summarize data on nine different ETFs, three of which track the S&P 500 Index. No matter how the indexes are created, though, there s been very little difference in performance for the past five years, with the exception of the Nasdaq 100. More on that below. Page 2, 2018 Advisor Perspectives, Inc. All rights reserved.
*represents compound annual returns A little bit about each index. The Russell 1000 Index is comprised of approximately 1000 of the largest companies in the U.S. equity market, and is a subset of the Russell 3000 Index. It represents about 90% of the total market cap of all listed U.S. stocks. The Schwab U.S. Large Cap ETF tracks the Dow Jones Total Stock Market Large Cap Index, which captures about 2/3 of the U.S. market. This index holds the top 750 companies by market cap and is rules based. In contrast, the S&P 500 Index is run by a committee and requires companies to be profitable along with needing at least 50% of their outstanding shares to be in public float (tradeable). The Schwab index requires just 10% of shares to be in public float. Then we have the Vanguard Large Cap ETF, which tracks the CRSP U.S. Large Cap Index, which captures the largest 85% of market cap in the U.S. CRSP stands for Center for Research in Security Prices. In contrast, the Vanguard Megacap 300 is composed of the largest 275 stocks which represent the largest 70% of the U.S. market. (Please don t ask why it is not called the Vanguard Megacap 275!). The Guggenheim Equal Weight S&P 500 (RSP), as noted above, gives every stock in the index an equal weight. As a result of this, it acts more like a midcap index than a large cap index. And, given its size, we felt compelled to include the Nasdaq 100 Index, also known as the QQQ. This index Page 3, 2018 Advisor Perspectives, Inc. All rights reserved.
represents the 100 largest non-financial companies in the Nasdaq Composite, but it really is not representative of the overall large cap segment. Rather, the index is weighted 50% to technology stocks. This has paid off in recent years, but it likely will not always be the case. Finally, as noted above, we looked at three ETFs, all of which track the same index, that of the S&P 500. What is interesting is that SPY, which has an expense ratio of just over 9 basis points, more than double than the ishares or Vanguard versions, has nearly double the assets of IVV and over 3 times as much as Vanguard. Mathematically, it cannot do better than the other two because its expense ratio is higher, and one should note it is also organized as a unit investment trust which means it is restricted from reinvesting dividends and also cannot equitize cash with futures or use securities lending revenue to offset expenses. So, with all those disadvantages, why does SPY have most of the money? It has to be liquidity, as institutions feel they can move in and out with tens of millions of dollars to increase or decrease exposure, in a more efficient manner than they can in the other two products. For retail or advisory clients who are buying and mostly holding though, owning IVV or VOO makes more sense. For every $100,000, one would earn $70 more per year in owning IVV or VOO. That won t make you rich, but it will pay for 25 Venti Pike coffees at Starbucks! With all the subtle differences, you can see that in the past five years, there is very little variation in performance from top to bottom, at 15.55% for the Russell 1000 to 15.66% for the Vanguard 500 and the Vanguard MegaCap 300. The higher expense ratio of the Russell 1000 ETF explains virtually all of its lag. The RSP and QQQ aren t really large cap indexes in the broad sense, and they fall outside those ranges, so it really isn t an apples to apples comparison when looking at them. The Mid Cap Indexes We begin to see much more disparity in performance when we go down the scale in size. Below is the data on the four midcap ETFs we looked at. *represents compound annual returns Page 4, 2018 Advisor Perspectives, Inc. All rights reserved.
There are significant differences in all time frames, likely suggesting that as you move down in the size of market cap, there are fewer and fewer efficiencies. The Russell Mid Cap Index is created by taking the 800 smallest stocks from the Russell 1000 Index (see above). Meanwhile, the Schwab Midcap ETF owns about 500 names, which tracks the Dow Jones Total Stock Mid Cap Index. The Vanguard Midcap ETF owns 330 names, and tracks the CRSP U.S. Mid Cap Index, while the S&P Midcap 400 is determined by a committee, much like its large cap counterpart. One of the criteria, besides size, for the IJH is that the company must be profitable for the past 4 quarters. As you can see, there is considerable variability in YTD performance, with the Schwab ETF gaining over 300 basis points more than the S&P 400 Midcap. Though they have attracted considerable assets, both the Russell and Vanguard ETFs for midcap stocks have lagged the others over 3, 5 and 10 years, with the S&P 400 Midcap gaining nearly 1% more annually during the last 10 years. An edge like that over 1 year doesn t mean much, but over 10 years is quite significant. I can t prove this, but my hunch is that the screen for profitability that Standard & Poors uses may be the subtle difference in the results. After all, in the long run, stock prices are driven by earnings growth, so if a company is not earning a profit, why would you want to include it in an index? The Small Cap Indexes There are even bigger gaps in small cap index performance, and once again, it is the S&P Index leading the way, while the Russell Index shows the worst long term performance. Side note I don t think this is a coincidence as Barron s publishes long term rankings of mutual fund families each year, and in the most recent version earlier in 2017, Russell Investments was ranked # 52 out of 52 fund families. They were also # 52 out of 58 for the last five years. Yet, they continue to attract significant amounts of money. Why? I think it s because people (both investors and advisors) don t do their homework. They are lazy. *represents compound annual returns Again, a little bit about each index. The Russell 2000 Index is made up of the largest companies from # 1001 to # 3000, by market cap. In other words, the bottom 2000 of the Russell 3000 Index. It is Page 5, 2018 Advisor Perspectives, Inc. All rights reserved.
certainly broader than any of the other 3 we are looking at, but that hasn t helped its performance. The S&P 600 Small Cap is determined by committee, and the companies must have a market cap ranging between $450 million and $2.1 billion, and must be profitable. Higher free float and volume are also important considerations to make the cut. The Schwab ETF tracks the Dow Jones U.S. Small Cap Total Stock Index, which holds 1750 companies, while there are about 1400 holdings in the Vanguard Small Cap offering, which tracks the CRSP U.S. Small Cap Index. Those companies must be smaller than the largest 85% by market cap, but larger than the smallest 2% of companies. As for performance, nothing can come close to the S&P 600 Small Cap in any of the three time frames that matter 3 years, 5 years and 10 years. And, as noted above, not only does the Russell 2000 Index have the worst performance, it also has the highest expense ratio at 0.20%. A terrible combination. Yet, it has the most assets under management. And you thought institutions and advisors were smart?? International Indexes (Developed Markets) If you think trying to decide what exposure to have in U.S. stocks is difficult, adding foreign exposure just makes things more complicated. How broad should one be? For more accurate comparisons, we are breaking our analysis in this area into two parts Developed Markets and Emerging Markets. What are those? In investing, a developed market is a country that is most developed in terms of its economy and capital markets. The country must be high income, but this also includes openness to foreign ownership, ease of capital movement, and efficiency of market institutions. Examples would include most of Europe, Canada and Australia, to name a few. In contrast, an emerging market is a country that has some characteristics of a developed market, but does not meet the standards to be a developed market. The economies of China and India are considered to be the largest emerging markets. Page 6, 2018 Advisor Perspectives, Inc. All rights reserved.
*represents compound annual returns Despite the almost identical names, there is a significant difference between EFA and IEFA. The former owns over 900 stocks in developed markets, and its large cap tilt steers it to large multi-national firms. The benchmark excludes South Korea and Canada, which accounts for about 8% of indexes in its peer group, and the most exposure is in Japan at 23% of the fund. The IEFA fund goes across 21 developed markets and owns more than 2500 stocks, so it is much more diversified. The Schwab entry owns 1100 stocks and does include South Korea and Canada. The Vanguard FTSE (Financial Times Stock Exchange) All World Ex-U.S. fund owns more than 3600 stocks and is 22% weighted in Japan. The Vanguard FTSE Developed Markets fund represents more than 86% of the market cap outside the United States and owns more than 2500 stocks. In an interesting twist, the index includes a 17% weight to Emerging Markets. Finally, the Vanguard Total International Index Fund owns stocks in over 40 countries. Regarding performance, first notice the 10 year numbers compared to the U.S. indexes above. Roughly, you are looking at about 9% compounded for domestic stocks versus just over 2% for international. We ve written about this topic in earlier newsletters, and won t delve further in this one, but we prefer to use relative strength comparisons to determine whether to own foreign equities (or not), not some fixed formula that says you should always own foreign in some certain percentage. Both the IEFA and VEA offer a combination of the lowest expenses and best long term performance, though the former does not yet have a 10-year track record. Emerging Markets Once again, when we look under the hood in this area, we find that the fund with the most assets has Page 7, 2018 Advisor Perspectives, Inc. All rights reserved.
produced the least return, in this case, the Vanguard MSCI Emerging Markets Fund (VWO). Its low expense ratio does not explain everything, since two of the other three competitors have similar ratios. The fund does own 3000 stocks, though South Korea is excluded. It would be quite easy to get confused, learning the difference between IEMG, the ishares Core MSCI Emerging Markets Fund, and EEM, simply the ishares MSCI Emerging Markets Fund. The former offering is the broadest of the choices here, owning 1800 stocks which cover 99% of the universe and spans 24 markets. China represents 28% of the fund. The EEM tracks the market cap weighted MSCI Emerging Markets Index, and owns 800 large and midcap stocks also spanning 24 markets. The two funds are almost identical in size, yet the EEM charges 0.69% annually in expenses, making one wonder why anyone would buy it over IEMG. Indeed, in the last 3 and 5 years, that difference in the expense ratio is what gives IEMG the edge in total return. Conclusions As hopefully the above has shown, there is a lot more to indexes than one would think. Being the cheapest isn t necessarily the best, and being the biggest doesn t always correlate with the best performance. Yet, when you have the highest expenses, such as with the Russell Indexes or the EEM, it has definitely contributed to lagging performance. Schwab has been a late entrant to this field, and they have tried to make up for that by having the lowest expenses across the board, but that hasn t really translated to assets yet. They have a really solid midcap offering, but apparently it is hard to get people to change. Overall, the ishares S&P Index offerings have several compelling choices in every area, and that is why we are using them for clients. It is just a bonus that many of them come with no trading commissions on the Fidelity platform. Vanguard is competitive in most areas except in Emerging Markets, yet they run the largest fund in that category. Go figure. All in all, it pays to do your homework. Bob Kargenian, CMT Page 8, 2018 Advisor Perspectives, Inc. All rights reserved.
President TABR Capital Management, LLC 500 N. State College Blvd, STE 1320 Orange, CA 92868 (714) 704-9180 Voice (714) 937-1886 Fax www.tabr.net TABR Capital Management, LLC Page 9, 2018 Advisor Perspectives, Inc. All rights reserved.