Untangling How Index Providers Break Down the U.S. Market by Size

One size does not fit all when it comes to how index providers segment the U.S. equity market.

Adam McCullough, CFA 30 May, 2019 | 9:00
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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.

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About Author

Adam McCullough, CFA  Adam McCullough, CFA, is an Analyst on Morningstar’s Manager Research Team, covering passive strategies.

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