Wall Street Secret: Most US Equity Indexes Are the Same. Not.

A captivating conversation with Retirement Subject Matter Expert, Larry Divers.

I bought Larry Divers a large latte with six shots of espresso, let him gulp it down then looked him sternly in the eyes and said, “are equity indexes really that different from each other? C’mon, once you have enough stocks in an index then the Law of Large Numbers will kick in and returns will be similar albeit with some rough sailing. Right?”

"Quote me as saying emphatically not,” Larry told me, so I did. “I get this question from the FAs I teach who live all over the country. I get it from friends. Neighbors. From relatives. I get it on the golf course, even at church."

Seems Larry can’t get any peace and quiet.

“Every client in your practice has different needs, wants, and wishes. You add value by creating the proper asset allocation, which will allow them to fulfill these needs, wants, and wishes. To do this, most FAs use a combination of traditional mutual funds, ETFs, and index funds.”

Simple concept, with a number of flaws: there are more than 9,000 mutual funds in the US alone according to the Investment Company Institute. This number exceeds the number of listed stocks on the NYSE and NASDAQ combined. (NYSE 2,400¹ & NASDAQ 3,100²).   

Rather than research this large universe of mutual funds, many FAs scan index funds and ETFs looking for funds which have Alpha returns—that is returns in excess of their benchmarks— to recommend to their clients. But you as an FA want an index fund/ETF which represents the depth and breadth of the total US equity markets.  Larry feels there are only two indexes which meet this requirement: the Standard and Poor’s Composite 1500® index and the Russell 3000® index. Of these, Larry favors the Russell 3000®. Why? 

The fifteen hundred stocks which comprise the S&P 1500® index are chosen by Standard and Poor’s U.S. Index Committee from a pool of stocks which meet certain criteria including liquidity, float and industry sector. Corporations must have a specific market capitalization to be considered for inclusion, in either the S&P 500® index, the 600® index or the 400® index which together comprise the S&P 1500® index.

Identities of the members of index committee and their deliberations are confidential. They make changes to the stocks in S&P 1500® whenever they conclude a stock no longer meets their criteria.  There is no annual “rank day” since there is subjectivity in the selection of the equities which make up the index. For a stock to “move in” one has to “move out.”³ Larry feels this process lacks a certain degree of transparency and borders on active management.

 The only truly objective measurement of the US equity market, said Larry, is the Russell 3000® index. Their methodology is simple. May is always the “ranking month.”  In a schedule announced in the spring, the firm specifies the date in May which will be “rank day.” In 2017 that date is May 12th.⁴ On the market close that day, the market cap of every publicly traded company in the US is calculated and the top 3,000 are ranked.  This is the lead up to “reconstitution day.”

 In June of each year, explains Russell on their website, the reconstitution portfolio is communicated to the marketplace. In 2017, this information was released on June 9th and “reconstitution day” was set for Friday, June 23rd with the new indexes taking effect after the market closes.⁵

Larry said the transparency and objectivity of the Russell 3000® is the key reason to choose it for client portfolios. “With the Russell 3000® index, you know exactly what you are getting since you know how it is calculated and when the index will be changed. They do this once a year and don’t tinker with it. Compared to the S&P 1500® index, the Russell 3000® index gives you the broadest possible exposure to the US equity markets. 3000® stocks versus 1500® stocks is a large difference, especially if the investor is using subsets of the indexes such as growth and value.”

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Resources: 

¹https://www.nyse.com/list

²http://www.nasdaq.com/reference/market_facts.stm  

³https://us.spindices.com/documents/methodologies/methodology-sp-us-indices.pdf

⁴http://www.ftserussell.com/research-insights/russell-reconstitution

⁵http://www.ftserussell.com/search/site/%22Russell%203000%22

Contributing Writer: Subject Matter Expert Charles McCain