Capitalizing on the Index Fund Advantage
by John Markese
And in the good old days, the selection decision was even easier because there were just a handful of stock index funds that covered an even smaller number of stock indexes.
Those days are long gone. Now, the myriad stock index funds and the numerous stock indexes they follow are no longer simple to sort out and understand.
Today, investors face the challenge of deciding:
- What segments of their stock portfolios to index and,
- How to choose among the indexes now available while assuming that those desirable attributes of index funds are present.
The first step in this decision process is to take a look at an organized and categorized presentation of stock index funds. Table 1 is just that type of resource.
The indexes in Table 1 are organized by stock capitalization (the number of shares outstanding times the market price per share): large cap, mid cap and small cap. Within each stock capitalization category, funds are grouped by the index they follow.
Why is it important to list index funds by stock-capitalization size?
Capitalization size highlights the potential for a stock index to provide diversification to your portfolio. Every index fund is well diversified in the sense that no individual stock holding will have a significant impact, positive or negative, on the entire index. However, from a different viewpoint—the impact that the fund will have on your own portfolio—the different cap-size indexes represent different industry weightings and stocks at different points in their lifestyles. In order for your own portfolio to be diversified, you will want exposure to all of these various stock groups.
Breaking down indexes by cap size also provides information to support a decision on what portion of a stock portfolio to index. For example, you may choose to use an index fund for your large-cap holdings, use an actively managed mid-cap stock fund for mid-cap holdings, and purchase individual small-cap and micro-cap stocks on your own for your small/micro-cap holdings. Alternatively, you may choose to simply use index funds for all of your holdings.
Let’s take a look at the large-cap indexes in Table 1. It is immediately obvious that the Standard and Poor’s 500 is by far the most popular large-cap index.
It’s been around for a long time and it is broad-based, diversified by industry and the stocks are chosen for cap size and liquidity. Large firms in the transportation, financial, manufacturing, service, energy and utilities industries are well represented. (See "The Indexes" box for brief definitions of the indexes in Table 1.) Like all the indexes underlying these mutual funds, it is capitalization-weighted: The larger the market cap of a stock, the more the stock’s return influences the index’s return—an important consideration for diversification that will be elaborated upon below when the questions of what and how to index are addressed.
The NASDAQ-100 index is large-cap also, but much different than the S&P 500. The NASDAQ-100 is made up of the 100 largest non-financial firms listed on the NASDAQ, and the industry emphasis is heavily on technology companies including biotechnology, telecommunications, computer software and hardware, and Internet firms.
The performance of the S&P 500 index funds and the NASDAQ-100 indexed Rydex OTC fund are as different as their industry/firm compositions. All the S&P 500 index funds have virtually identical performances; differences are primarily due to differences in annual expense ratios. The Northern Stock Index fund has an expense ratio of 0.52% annually, while the SSGA S&P 500 fund has an expense ratio of just 0.15%. The difference in these two funds’ five-year average annual returns is very close to this annual expense ratio difference. Because the Rydex OTC fund has a different—but still large-cap—underlying index, its performance versus the S&P index funds is substantially different. And it is not just because the Rydex OTC fund carries a high expense ratio of 1.20%—far above the average index fund expense ratio and even above average for all stock funds. Much of the return difference and the difference in year-to-year performances of the NASDAQ-100 index fund and the S&P 500 index funds is risk, as summarized by the total risk ratio of 1.75 for the Rydex OTC funds compared to the average 0.93 total risk index of the S&P 500 index funds. The total risk ratio compares the variation in return of a fund over three years, using standard deviation, to the average variation in return of all other mutual funds (including bond funds and foreign funds). The average total risk index for all funds is 1.00, so the Rydex OTC fund is 75% more volatile than average and the S&P 500 funds are 7% less volatile than the average mutual fund.
The Schwab 1000 index simply tracks the 1,000 largest companies and moves down the capitalization-size line past the S&P 500 index. The two indexes track each other in terms of performance and risk very closely.
The Vanguard Growth Index fund and the Vanguard Value Index fund track Morgan Stanley Capital indexes for growth and value selected from the 750 largest U.S. firms. And here, because the firms are selected with growth and value criteria initially but managed as indexes, the performances and risks are markedly different.
The three funds indexed to the Wilshire 5000 (although the Vanguard fund is transitioning to another index) are all total stock market indexes and it may seem odd that they are classified as large-cap index funds. The Wilshire 5000 is made up of just about every stock traded on a U.S. exchange with readily available pricing information. This leaves out stocks that are traded on the bulletin board, or the over-the-counter, market. How many stocks are in the Wilshire 5000? Well, it’s no longer 5,000, but more like 6,700.
But why are these funds classed as large-cap when they track so many micro-cap and small-cap stocks?
The answer is that, again, this index is capitalization-weighted, and larger stocks affect the indexes’ performance proportionally more. The S&P 500 alone is equal to about 77% of the total market capitalization of all U.S. stocks. In other words, large-cap stocks drive this total stock market index. It is clear from a simple visual comparison of the performance and risk of the Wilshire 5000 index funds to the S&P 500 index funds: The performance numbers, while not identical, move in the same direction and magnitude. The Fidelity Spartan Total Market Index fund and the Fidelity Spartan 500 Index fund have a correlation of returns over three years of 0.99, just shy of a perfect correlation of 1.00. Figure 1 illustrates this point further by graphically comparing the performance of the Wilshire 5000 to the S&P 500, the S&P MidCap 400 and the S&P SmallCap 600.
If you are thinking of indexing all your stock positions and you want to make sure that you are diversified across large-cap, mid-cap and small-cap markets, then a fund indexed to a total market index will not work—it will effectively follow large-cap stocks.
A look at the performance of the stock index funds indexed to mid-cap indexes underlines the value of diversification by stock capitalization. Mid-cap stocks are a bit more volatile than large-cap stocks, with somewhat higher average total risk measures. However, their performance—particularly over the entire bull and bear market periods and year-by-year—varies significantly from the large-cap index funds. That means that they offer important diversification benefits to your portfolio.
Why do you need to go with a separate mid-cap index fund rather than an all-inclusive total market fund? Once again it is a question of dominance. The MSCI US Mid Cap 450 index represents only 15% of the total market capitalization of all U.S. stocks and is easily overpowered by large-cap stocks when part of a total market index. If you want more representation in the mid-cap sector for diversification, you need a separate fund.
The small-cap index choices have the most variety by index and by cap size within the small-cap range.
The Bridegway Ultra Small Company Market fund follows the CRSP 9-10 index, the smallest of these listed small-cap indexes. The CRSP 9-10 is a micro-cap index that determines the smallest 20% of the firms listed on the New York Stock Exchange, and then it includes all of these stocks plus all stocks on the NASDAQ and Amex within the same cap-size range.
Compare the performance and risk of the Bridgeway fund to the Vanguard Small Cap Index fund (based on the MSCI US Small Cap 1750 index), and it is clear that the numbers are significantly different.
Ironically, the three extended market funds that are based on the Wilshire 4500 (the Wilshire 5000 less the S&P 500), which are dominated by mid-cap stocks, track the Vanguard Small Cap Index fund more closely than the Bridgeway Ultra Small Company Market fund. But despite their differences, any one of the small-cap index funds listed here will provide diversification within the small-cap arena and are not dominated by any large-cap stocks.
The CRSP 9-10 tracks micro-cap stocks. The CRSP indexes rank all NYSE companies by market capitalization and divides them into 10 equally populated portfolios. The CRSP 9-10 covers the bottom 20%. Amex and NASDAQ stocks are then included based on the NYSE market capitalizations.
MSCI US Mid Cap 450
MSCI US Prime Market
MSCI US Small Cap
S&P MidCap 400
Schwab Small Cap 1000
Here are some important points to consider when you are making decisions on indexing your stock holdings:
Indexing benefits include lower expenses, tax efficiency, simplicity and diversification. When it comes to expenses, it is difficult for the portfolio manager of an actively managed mutual fund to beat an index fund of the same risk over time when the index fund has an annual expense ratio of 0.20% and the active manager has an expense ratio of 1.20%. A 1.00% difference in returns due to expenses for an index fund earning 8% after expenses versus an actively managed fund earning 7% after expenses results in an advantage of over $79,000 for the index fund on a $100,000 initial investment over 20 years.
In order to truly diversify among the stock-capitalization classes—large, mid and small—you cannot employ a total market, capitalization-weighted stock index. More effective diversification can be achieved by allocating your index fund commitment to a large-cap, mid-cap, and small-cap index fund—for example, one-third to each cap-size index. Micro-cap stock index funds probably rate their own separate category so, for example, one quarter can be allocated to each cap-size range—micro-cap stocks the fourth—to be sure of broad diversification.
The most efficient segments of the stock market—the segments where detailed information is readily available on stocks and there are many analysts following the stocks—make the most sense to index. It is basically too difficult for active fund managers to overcome the cost advantage of index funds in very efficient segments of the market. Think seriously about indexing the large-cap portion of your stock portfolio allocation.
Conversely, the least efficient segments of the market—small-cap and, very particularly, micro-cap stocks—make the best candidates for active management. A sharp, active portfolio manager in the small/micro-cap area should be able to overcome the cost advantage of a small/micro-cap stock index fund. What’s the hitch? Picking the right actively managed small/micro-cap fund isn’t simple.
- If you want all the advantages of index funds—including simplicity—then simply index the four cap-size corners of the stock market, one by one. That way, you will have all of your bases covered, with no cap size dominating your portfolio—true diversification.
|Exchange-Traded Funds—The Index Fund Alternative|
|You don’t need to stick with index mutual funds in order to use the index fund approach. Exchange-traded funds—ETFs—are an alternative to traditional index mutual funds that have started to attract considerable investor interest. These funds are similar to index mutual funds, but are listed on an exchange and trade just like an individual stock. For more on exchange-traded funds, including a complete listing of available ETFs and the indexes they track, see “The Individual Investor’s Guide to Exchange-Traded Funds,” in the October 2005 AAII Journal (also available at AAII.com).|