Choosing a Better Index ETF

Popular indexes can make for flawed index funds. The Dow Jones Industrial Average, S&P 500, Russell 2000, and Nasdaq 100 gather the lion’s share of headlines, but some make better investments than others.

The earliest indexes were not designed to be investments. Each of the four U.S. index goliaths was developed before State Street launched its transformative S&P 500 ETF Trust SPY in 1993, and two before the first mutual fund tracking the S&P 500 in 1976. The DJIA was created in 1896 as a revolutionary way to measure stock market activity. The S&P 500—in its current form—debuted in 1957 as a more fulsome gauge of stock market health with added breadth covering the 500 largest stocks traded on U.S. exchanges. The Russell 2000 and Nasdaq 100 are relative newcomers, created in 1984 and 1985, respectively; the former was designed as a comparator for active small-cap mutual funds and the latter was developed as a marketing engine for the burgeoning Nasdaq exchange.

The S&P 500 stands above the rest for its investment merit and investability. Its selection criteria require profitability and its committee decisions remain a touch arbitrary, but its market-cap-weighted portfolio is a well-diversified representative of the large-cap U.S. stock market. You can read our full analysis of Gold-rated Vanguard S&P 500 ETF VOO here.

In this piece, we examine flaws of the DJIA, Nasdaq 100, and Russell 2000 as well as present some index exchange-traded fund alternatives investors should consider.

Dow Jones Industrial Average—Old Dog, Same Tricks

Despite the DJIA’s prominence as a market gauge, its age shows. Its blue-chip ethos remains, but its 19th-century origins do not translate to a worthwhile investment offering today.

SPDR Dow Jones Industrial Average ETF DIA tracks the index to near perfection, but it inherits the benchmark’s flaws:

• The portfolio is highly concentrated with just 30 stocks and more than 50% of assets routinely allocated to its top 10 holdings.
• Index inclusion criteria are opaque—an unnamed index committee seeks companies that have a stellar reputation and are most representative of the U.S. economy.
• The portfolio is price-weighted, which has no sound economic rationale and constrains the investment universe. Most indexes today are market-cap weighted to reflect company size more accurately.
• Changes to the index are made on an as-needed basis with no regular review period.

All of the above introduce considerable active risk to what should be a passive index. The Process Pillar rating of DIA is limited to Below Average as a result. You can read our full analysis of DIA here.

The DJIA is an artifact of a different age. Today, investors have better options available when selecting an index ETF. The table below highlights some highly rated alternatives.

Source: Morningstar. Data is as of May 31, 2023.

The indexes behind offerings from Vanguard, iShares, and Schwab are driven by quantitative processes that systematically add and remove stocks based on investability criteria—like market cap and liquidity, rather than subjective or incomplete measures. All are also significantly more diversified and capture far more of the investment universe than SPDR’s DIA. Market-cap weighting and these light-touch criteria help steer them away from the active risk incurred by DIA while maintaining a representative portfolio of the U.S. stock market.

Nasdaq 100—Excellent Performance Has Masked Construction Deficiencies

Invesco QQQ Trust QQQ has compiled a track record that few can rival, with its returns ranking among the top 2% of its large-growth Morningstar Category peers over the trailing five-, 10-, and 15-year periods. Yet its benchmark, the Nasdaq 100 Index, has flaws that cast doubt on the durability of its superb performance:

• The index exclusively admits stocks that trade on the Nasdaq exchange and spurns the rest. This is driven by Nasdaq’s desire to promote its exchange—not economic rationale. The index denies firms like Unitedhealth Group UNH, Exxon Mobil XOM, and The Home Depot HD for no reason other than where they trade.
• Only nonfinancial stocks are considered. Financials represent a small share of most growth strategies anyway, but this narrows the index’s opportunity set.
• The portfolio is top-heavy. Its top 10 holdings constituted between 49% and 59% of the portfolio over the past five years.
• Sector concentration is a concern. At the end of May, about 82% of the portfolio was stashed in technology (51%), communications (17%), and consumer discretionary stocks (14%).

QQQ’s robust liquidity prompts many investors to use it as a proxy for technology exposure, though only about half the portfolio comprises tech stocks. Other investors treat it as a diversified large-cap portfolio. However investors use the fund, better alternatives exist. You can read our full analysis of QQQ here.

The table below features tech ETFs that offer cleaner exposure to the sector, as well as diversified large-growth portfolios whose broader reach and more-sensible index construction makes them better all-around investments. All come at a lower price, too.

Source: Morningstar. Data is as of May 31, 2023.

Russell 2000—A Flawed Small-Cap Index

Unlike the Dow Jones Industrial Average and Nasdaq 100, the Russell 2000 is well diversified across stocks and sectors. But diversification alone is not enough to bring this bogy up to par with the best benchmarks in the small-blend category.

The small-cap market is a fickle beast, with thousands of volatile small- to micro-cap companies populating the opportunity set. Unlike index competitors, the Russell 2000 lacks some key features to address the illiquidity inherent to its target market and mitigate its drag on fund returns:

• No buffer rules around its lower market-cap threshold, which increases turnover and associated transaction costs.
• Rebalances occur annually, which forces funds tracking the index to concentrate rebalancing orders on one date. This increases the market impact from their orders—meaning purchases will occur at increasingly high prices while sales are at decreasing prices—and the mismatch between the large orders and illiquid stocks can result in poor execution quality for funds.
• Favors smaller stocks than some competitors. With no risk control measures it may fall further than its peers when markets sour.

These shortcomings limit the Process Pillar rating of Vanguard Russell 2000 ETF VTWO to Average. A low fee of 0.10% helps VTWO earn a Morningstar Medalist Rating of Bronze. You can read our full analysis of VTWO here.

Investors should look beyond funds tracking the Russell 2000 to achieve the best outcomes. Indexes from CRSP, Dow Jones, and S&P do a better job managing risks inherent to the small-cap market, and funds tracking those benchmarks earn higher Process Pillar ratings because of it.

Source: Morningstar. Data is as of May 31, 2023.

The Russell 2000 does a good job of tracking the small-cap market but is lacking as an investable product. The other ETFs profiled above also capture the segment well but incorporate key features like buffer rules and strict liquidity screens to make them compelling investments. Investors should consider one of those if seeking broad small-cap exposure.

Closing Thoughts

The most discussed indexes don’t necessarily make the best index funds. The DJIA, Nasdaq 100, and Russell 2000 are frequently cited by pundits but are flawed investment products.

Today, those popular market gauges have billions of dollars tracking their every move despite lacking the modern features of indexes specifically designed with investors in mind. Investors should steer clear of funds tracking them.

The best indexes in any market segment are well-diversified and take a rules-based approach to construction and maintenance. The suggested alternatives to each flawed index track a benchmark that better manages the unique risks of each segment and incorporates operational rules that make their constituents easily investable.

The Verdict

Products like Vanguard Total Stock Market ETF VTI, iShares Core S&P US Growth ETF IUSG, and Schwab US Small Cap ETF SCHA effectively capture their target universe while controlling for unnecessary costs and risk. Excellent ETFs like these should be on investors’ shortlist instead of those following imperfect indexes.