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Market Basics: What is an Index and Why do we Track It?

WHAT IS AN INDEX?

Investors often hear their advisors refer to an Index. But what is it?

Index = the compilation of a large group of assets that share some similar characteristics.  There are many indices out there for a variety of asset types, segments of the market, etc.

For this article’s purposes, we are going to focus on the S&P 500 Index.  The Standard & Poor’s 500 Index was created in 1957 and consists of the 500 largest companies in the United States.  When we say “largest,” we are referring to Market-Capitalization.  

Market-Capitalization = Outstanding Number of Shares x Value of One Share

This has nothing to do with sales numbers, labor force, industry performance, quality of management, etc.  There are some other basic criteria that you would expect to see for a major company in the United States; but for the most part, inclusion in the S&P 500 Index has everything to do with Market Capitalization.

One might assume that these industry giants are fairly well-diversified.  If you buy shares in the S&P 500 through any one of a number of mutual funds offering that investment, you think you are getting broad exposure to the US corporate landscape.  Well, you may not be getting as broad an exposure as you think.

On February 28th, 2019, more than 20% of the entire Index consisted of 9 companies (Google is in there twice because they have 2 different share classes).Those companies were:

Top 10 by Index Weight

ConstituentSymbolSector*
Microsoft CorpMSFTInformation Technology
Apple Inc.AAPLInformation Technology
Amazon.com IncAMZNConsumer Discretionary
Berkshire Hathaway BBRK.BFinancials
Facebook Inc AFBCommunication Services
Johnson & JohnsonJNJHealth Care
JP Morgan Chase & CoJPMFinancials
Alphabet Inc CGOOGCommunication Services
Alphabet Inc AGOOGLCommunication Services
Exxon Mobil CorpXOMEnergy

While there is absolutely nothing wrong with buying an index (we buy them too!), do not make the mistake of believing that a market-cap index alone qualifies as diversification.  Large companies often have a very positive performance history (It’s how they got so large after all!), but there are other opportunities and types of companies out there that could provide more growth during up-markets and/or protection during down-markets. 

In addition to market-cap weighted indexes, there are also other passive/active hybrid options that invest in other types of qualitative criteria.  For instance, WisdomTree’s Quality Dividend Growth ETF (DGRW) invests in companies that meet a certain dividend-growth criteria. This is a newer trend, and it goes by a number of names:  SmartBeta, Fundamental Indexing, Alternative Indexing.   In fact, the name of this trend is something of a joke in the industry because they can’t seem to agree on what to call it.We can’t say that it is superior to traditional market cap indexing, but it is another option out there to better diversify your portfolio.

WHAT IS ACTIVE VS PASSIVE INVESTING?

A traditional market-cap index like the S&P 500 is considered a Passive Investment.  As explained above, the company doesn’t have to do anything special to be included in a market-cap index.  It just has to meet a certain data point.  There are no additional rankings for Quality.  If you want to also include quality in your criteria, then you should hire an Active Manager.  An actively managed mutual fund, ETF, or investment advisor learns about the company from all angles to determine if they want to invest in it.  A large company does not necessarily mean a good one, and a small company does not necessarily mean it won’t be profitable. 

ILLUSTRATING THE BENEFITS OF DIVERSIFICATION

So how does one know if one’s portfolio is diversified?  We suggest using a blend of active and passive; large and small cap companies; domestic and international; and overweighting areas that may provide either growth or protection depending on the market environment.

For purposes of an example, we have selected two indexes (passive) and two mutual funds (active) in domestic stocks.

See the performance chart below*:
Performance   ending 2/29/19
Name of Asset/IndexYTD1 Year3 Years5 Years10 Years
S&P   500 Index11.48%4.68%15.28%10.67%16.67%
Price   New America Growth (PRWAX)14.47%8.23%21.00%12.80%18.81%
Russell   2000 Index17.03%5.58%16.67%7.36%16.60%
Price   Small Cap Growth Fund (PRDSX)16.78%7.27%17.7%9.41%19.31%

As you now know, the S&P 500 Index consists of the largest US companies by market-cap weight.In contrast, the Russell 2000 Index includes smaller market-cap companies in the US.  There is no overlap between them.

The T. Rowe Price New America Growth Fund (PRWAX) is an actively managed mutual fund that focuses on large cap growth companies.  Currently, the fund consists of about 52% in large cap growth, with the remaining companies in other large cap and midcap companies.  In contrast, The T. Rowe Price Small Cap Growth Fund (PRDSX) is an actively managed mutual fund where most of its companies fall in the small and mid cap growth range.  There is no large cap in the fund.  We use both of these funds in our client portfolios.

As you can see from the chart, for the first two months of 2019, the Russell 2000 Index is beating the other three options.  For the past year, Price New America Growth is ahead.  For the past 3 years, Price New America Growth was significantly ahead of the other 3 options.  For 10 years, if you compare the best performer to the worst performer, you’ll see that the actively managed Price Small Cap Fund is ahead of the Russell 2000 Small Cap Index by about 2.7% annualized, which translates to 27% for 10 years.  That’s a big difference!

Are we saying that you should have invested all of your money in T. Rowe Price’s Small Cap Fund?Absolutely not.  There is no crystal ball, and the market does not follow any set rules.  Ten years ago, we could not have predicted the outcome of the chart above.  What you can do is stay truly diversified by using all the options available to you.  That includes active and passive investments and understanding what those investments include.

WHY DO WE TRACK IT?

When we manage your portfolio, we want to see how we’re doing and how it translates in real dollars to you.  The best way to do that is to choose an industry- recognized target to aspire to and beat.

When we manage an equity portfolio, for instance, we use a blend of the Russell 3000 (largest 3000 companies in the United States by market-cap) and the MSCI ACWI ex US Index (All those letters translate to a global stock index that does not include US stocks) as our target.   We then report it to you, whether we are happy with our results or not. 

We welcome your feedback on this article and others.  If you have additional questions about indexes or the makeup of your portfolio, please reach out to your investment advisor.

-Danielle Woods

* Past performance is no guarantee of future performance.  A list of all assets that Propel currently invests in for clients is available upon request.