Untangling How Index Providers Break Down the Market by Size

Index providers take different approaches to partitioning the U.S. equity market by size. S&P Dow Jones Indices divvies up market size segments by rank, ordering stocks by their market capitalization and assigning a fixed number of stocks to its large- (S&P 500), mid- (S&P MidCap 400), and small-cap (S&P SmallCap 600) size segments. The Center for Research in Security Prices, or CRSP, carves up the market using market-cap breakpoints. For example, stocks representing the top 85% of its universe of U.S. stocks make up its large-cap index. These methodological differences seem small, but they lead to the risk that investors may unknowingly create overlapping size-segment exposures--even if they own funds tracking indexes from the same index family. This is because these index families' market-cap segments are not always mutually exclusive. Here, I'll explore this risk and its implications for portfolio construction.

An article published in the August 2017 issue of Financial Planning titled "Three Against One" [1] highlights common misconceptions about how index providers segment the market by size and how investors might piece it back together again. In the article, the author argues that investors can outperform a total stock market index fund by owning a large-, mid-, and small-cap U.S. equity index fund in proportion to their share of the total market cap of the total market index and rebalancing annually. Of course, this shouldn't be the case.

The issue with this analysis stems from the fact that the author compares the performance of a three-fund portfolio made up of Vanguard 500 Index VFINX, Vanguard Mid-Cap Index VIMSX, and Vanguard Small-Cap Index NAESX to that of Vanguard Total Stock Market Index VTSMX. The author allocates 70% of the portfolio to Vanguard 500 Index, 20% to Vanguard Mid-Cap Index, and 10% to Vanguard Small-Cap Index. He rebalances back to these weightings at year-end.

The author mixes and matches S&P index breakpoints with three funds that track an S&P benchmark and a pair of CRSP indexes. Remember, S&P indexes bucket stocks into market-cap segments by count while CRSP uses cumulative market cap. Also, while the author uses historical performance for the Vanguard mid- and small-cap index funds, he fails to account for the fact that these funds switched from MSCI indexes to their current CRSP benchmarks in early 2013. As such, their performance prior to 2013 doesn't represent CRSP indexes' performance.

Even if we correct for these inconsistencies by using the historical performance of the CRSP indexes over the same time period, the author's argument fails to hold water. This owes to the apparent confusion regarding the CRSP indexes' size-segment breakpoints and thus the market-cap coverage of the funds these benchmarks underpin. CRSP defines mega-cap stocks as those that represent the top 70% of the U.S. market by market cap. By CRSP's definition, stocks making up the next 15% of the U.S. market's aggregate market cap are mid-cap stocks. But CRSP defines the large-cap segment as the top 85% of U.S. stocks ranked by market cap. CRSP's large-cap index is a combination of its mega-cap and mid-cap indexes. If an investor holds funds that track the CRSP large-cap, mid-cap, and small-cap indexes, they will create overlapping mid-cap exposures as compared with the total market index. Thus, the author generates better returns by (unintentionally) overweighting mid-caps. When it comes to portfolio construction, it's crucial to remember that index providers' market-cap segments are not always mutually exclusive.

'Yeah, Well, That's Just, Like, Your Opinion, Man' Little Lebowski Urban Achievers will recognize this classic quote from Jeff Bridges' character "the Dude" in the movie The Big Lebowski. Index providers have different ways of carving up equity market size segments. Their naming conventions for these size-oriented benchmarks can contribute to the confusion around size-segmentation standards. In this section, I'll highlight the differences in size-segmentation definitions among the four most prominent families of U.S. equity benchmarks: S&P, Dow Jones, Russell, and CRSP.

All four index families rank U.S. stocks that meet their index eligibility criteria by market cap. S&P, Dow Jones, and Russell have count-based size breakpoints. For instance, Russell assigns the largest 1,000 companies by market cap to the Russell 1000 Index. CRSP divvies up names among size segments on the basis of cumulative market cap. The CRSP U.S. Large-Cap Index represents the companies that make up 85% of the U.S. market cap. Exhibit 1 below offers a summary of these index families' breakpoints.

Looking at Exhibit 1, you will notice that three of the four families' mid-cap segments overlap with their large- and/or small-cap segments. The CRSP U.S. Mid-Cap Index captures stocks representing 70% to 85% of U.S. market cap and overlaps 100% with the CRSP U.S. Large-Cap Index. The Russell Midcap Index represents stocks ranked from 201 to 1,000 by market cap and overlaps 100% with the Russell 1000 Index. Dow Jones whittles out its mid-cap index from its large- and small-cap indexes. In fact, only the S&P MidCap 400 Index is mutually exclusive from its large- and small-cap indexes. Another way to frame this is to examine the percentage of the market cap of each family's total market index that each size segment index represents. In Exhibit 2, I show each family's size-segment index's percentage of market-cap coverage of the U.S. equity market. I used Vanguard Total Stock Market ETF VTI to represent the total U.S. equity market.

Go for the Gold All four index providers' large-cap indexes cover more than 80% of the U.S. equity market. Interestingly, there is only one index-tracking fund that covers micro-cap stocks. IShares Micro-Cap ETF IWC covers the Russell Microcap Index. This fund held 1,440 stocks as of the end of March 2019 but only represented 1.3% of the entire U.S. equity market. Indexing is difficult in the smallest, most illiquid segments of the market because transaction and market-impact costs detract from performance. This limits the attractiveness of IWC. But as we move further up the market-cap ladder, exchange-traded funds tracking broadly diversified, market-cap-weighted, size-segment benchmarks earn higher marks. Exhibit 3 shows the ETF with the highest Morningstar Analyst Rating across each index family by size segment.

The highest-rated ETFs that track S&P, Dow Jones, and CRSP indexes earn Morningstar Analyst Ratings of Gold or Silver. In fact, only the mega-cap offerings from S&P and CRSP earn Bronze and Silver ratings, respectively (Dow Jones does not offer a separate mega-cap index). Notably, the funds that track the Russell family of indexes don't earn marks as high as their peers.

Vanguard Russell 2000 ETF VTWO and iShares Russell 2000 ETF IWM suffer from higher transaction costs than index peers because the Russell 2000 Index doesn't apply buffer rules to mitigate turnover among the smallest, most illiquid stocks. It adds and removes securities if their market-cap ranking barely crosses the 3,000-count selection threshold, even if the change does not have a material impact on the portfolio's characteristics. Compounding the issue, the Russell 2000 is a popular small-cap index with a lot of money following it, so the demand for liquidity is higher. These concerns limit the Analyst Ratings of the cheapest Russell 2000-tracking ETFs to Bronze.

Conclusion It's vital to get a grip on index construction when selecting among funds pegged to size-segmented indexes. Rather than attempt to recombine various market-cap strata, for most investors the best option is probably to keep it simple--gaining U.S. equity exposure in one fell swoop with a fund tied to a total market index. Gold-rated total stock market index funds such as iShares Core S&P Total U.S. Stock Market ETF ITOT, Schwab U.S. Broad Market ETF SCHB, and Vanguard Total Stock Market ETF are all terrific options for one-stop shoppers. Each of these funds tracks well-constructed indexes, covers nearly the entire investable U.S. equity market, and levies a single-digit basis-point fee.

[1] Israelsen, C. 2017. "Three against one: A battle of index funds." Financial Planning Magazine. Aug. 9, 2017. https://www.financial-planning.com/news/three-against-one-a-battle-of-index-funds.

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