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

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.

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.

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