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By Michael Rawson

Because of their low costs, exchange-traded funds are increasingly seen as the optimal vehicle to obtain passive market exposure. And while ETFs are often demonized for offering too many niche, "strategy" ETFs, the truth is that the bulk of ETFs assets are invested in passive, market cap weighted funds. But when it comes to obtaining the right passive exposure, investors face myriad choices. For example, there are ETFs that follow competing indexes from providers, such as Standard & Poor's, Russell, Dow Jones and MSCI.

While the large number of options available allows investors to fine-tune their portfolios or implement tactical trading ideas, the amount of industry jargon can seem overwhelming, particularly when there are no standard naming conventions. On top of that, the structure of indexes is not always the result of thoughtful design but is influenced by competition between index families, trial and error in determining what will be acceptable in the marketplace, and their own legacy.

Each index divides the universe in different ways and follows slightly different construction methodologies. Do these differences matter? Is it best to buy one single fund that covers the entire stock market or several funds that cover specific market-cap ranges? Is it acceptable to mix and match funds from different index providers? In this article, we will address some of these questions and provide some background information on the different indexes.

Within the ETF landscape, there are four main equity index providers offering a suite of indexes that cover the vast majority of the U.S. equities market and slice it in a number of different ways, for example, by market-capitalization range or by style. Among ETF issuers that follow these comprehensive indexes, Schwab Funds follow the Dow Jones index family, State Street offers ETF products from S&P, iShares offers ETFs that follow both Russell and S&P indexes, while Vanguard offers funds that follow MSCI, S&P and Russell indexes.

One Size Fits All Or Tailor-Made?

Perhaps the primary use of index-based ETFs is to gain passive exposure to the broad market. For an investor who prefers simplicity and low cost, a broad index ETF can replace a handful of mutual funds and provide similar exposure at a lower cost. For example, Vanguard Total Stock Market ETF (VTI) covers the entire U.S. equity market for an expense ratio of just 0.07%.

A more active investor can take advantage of the available subindexes to overweight certain size or style segments of the market. For example, in the Morningstar ETFInvestor Hands-Free portfolio we are trying to capture the small-cap premium, the tendency for small-cap stocks to outperform over the long term. By using Vanguard Mega Cap 300 Index ETF (MGC) (which has an expense ratio of 0.13%), Vanguard Mid-Cap ETF (VO) (0.12%), and Vanguard Small Cap ETF (VB) (0.17%) to gain exposure to U.S. equities instead of just one fund, we can easily adjust our allocation to each market-cap segment.

To cover large-, mid- and small-cap stocks in the same proportion as the market, these three funds would have to be combined in proportions of 73%, 16% and 11%, respectively, which would result in a weighted average expense ratio of about 0.13%. This would still leave out the micro-cap stocks that are in VTI, though these stocks are so small, they make up less than 1% of VTI. While using three funds to gain total market exposure gives us the flexibility to adjust weights, we pay a slightly higher fee. We would also incur three times the commission charges, so the single-fund approach is probably better for those with just a few thousand dollars to invest where the fixed commission charge will eat a larger percentage of your investment.

Can We Mix and Match?

While the core indexes from each of the providers are generally similar, if you decide to use the style or size segment indexes, it is best to avoid mixing indexes from one provider with another, unless you are comfortable with the overlap that this would create. It would not make much sense to hold a large-cap Russell 1000 fund with a MSCI Small Cap 1750 fund because 33% of the MSCI is already in the Russell. Indexes from the same family are designed to avoid this overlap. This stems from the fact that there is no standard size or style definition, so while one index might classify one stock as "mid-cap growth," that same stock might be "small-cap value" in another index.

Uses of Index-Based ETFs

There are a number of ways the index-based ETFs can be used beyond providing long-term beta exposure, such as portfolio completion strategies, tactical strategies, tax management or for cash equitization. Index ETFs can be used to supplement active portfolio managers or to avoid overlap with existing portfolio holdings while still providing coverage of the entire market. Let's say you already own a handful of mutual funds. Looking at the Morningstar Instant X-Ray tool, you can tell if, collectively, these funds cause your portfolio to be overweight large-growth funds. Although you are happy with these funds and do not want to sell them, you are concerned about the growth bias. As a counterweight, you can select a large-cap value index fund.

For more active investors with an investment thesis on a particular market segment, index ETFs offer the ability to target broad segments of the market to implement an investment idea. For example, you might have the opinion that large-cap value stocks are more attractive than small-cap growth stocks. Or you might use index ETFs to implement a pairs trade. Let's say you think small-cap stocks are overvalued relative to large-cap stocks - you might buy a Russell 1000 ETF and sell short a Russell 2000 based ETF. One way that index ETFs can be used for tax management is in the avoidance of the wash sale rule. This rule limits investors from selling a security to reap a tax loss, then buying it back within 30 days.

Here, an index ETF from one provider could be substituted for another and still give essentially identical exposure without triggering that rule. Studies have shown that market-timing can be extremely difficult and that missing just a few days in the market can cause a large deviation from the market average, so it makes sense for the passive investor to put cash to work rather than have it sit idle and for the active investor to park cash in ETFs while looking for the next trade opportunity. Cash equitization is particularly useful for institutions that are paid high fees to provide exposure to an asset class, not sit on the sidelines with cash in a bank account. However, one must be mindful of commission costs, particularly for small dollar trades.

Index Construction Details

Each index provider starts with an all-encompassing index that attempts to cover the vast majority of the publicly traded securities market and defines their universe of stocks. All of the other U.S. equity indexes from that family will be a subset of this index. S&P and Dow Jones use the phrase "total market" to describe this index, while Russell calls it the "3000E" ("E" for "extended beyond the first 3,000 stocks"), and MSCI calls it "broad market."

To be eligible for inclusion in their indexes, securities must meet certain eligibility requirements. For example, over-the-counter securities, special-purpose acquisition vehicles, royalty trusts, limited partnerships, closed-end funds and ETFs are generally excluded. Stocks must meet minimum price, market-cap and volume criteria. Typically, a firm must be incorporated or headquartered in the United States to be included on a U.S. index; however, providers differ in their allowance for exceptions to this rule and the extent to which they factor in other information such as location of the company's assets, revenue, income and the domicile of the stock exchange on which its shares have the most liquidity.

An Investable Subset

While the all-encompassing indexes attempt to be exhaustive in their scope, some argue that they are not investable because they include micro-cap stocks. Micro-cap stocks are so small and illiquid that it is difficult for a large fund manager to easily trade them without affecting their price. For example, the median market cap of a company on the MSCI Micro Cap Index is just $69 million. The SPDR S&P 500 alone has $80 billion in assets. If too much passive money flowed into micro-caps, it could quickly distort prices in that illiquid market. Depending on how you define the cut-off point, micro-caps typically make up less than 3% of the aggregate value of the stock market, so they have a minimal impact on returns.

Russell calls its investable subset the Russell 3000, while S&P goes by the S&P Composite 1500. MSCI has the Investable Market 2500 Index. Like MSCI, Dow Jones also uses 2,500 stocks, but it is called the Dow Jones Broad Stock Market Index (not to be confused with the MSCI Broad Market Index, which includes micro-caps). Despite the differences in the number of stocks, particularly between the Russell 3000 and the S&P Composite 1500, they each had more than a 99% correlation of return over the past 10 years. For new investors choosing an index among these four, the lower-cost options are probably best. Schwab U.S. Broad Market ETF (SCHB) charges 0.06%. Vanguard Total Stock Market charges 0.07% but follows the MSCI Broad Market Index, so it encompasses micro-cap stocks while Schwab's fund does not.

From here, the investable market is divided into large, mid- and small caps. S&P defines the largest 500 companies as large, the next 400 as mid-cap, and the final 600 from the S&P Composite 1500 as small cap. MSCI and Dow Jones use the first 300 as large, the next 450 as mid, and the final 1,750 from the top 2,500 stocks as small. As we move down the cap range, stocks tend to become more volatile, and it takes more of them to accumulate to significant size, so it makes sense that a mid-cap index should contain more stocks than a large-cap index and a small more than a mid. The odd grouping of S&P's indexes reflects the appendages of an evolutionary process, while the designed approach of MSCI and Dow Jones had the benefit of starting from a clean slate. Russell breaks the market-cap range into two buckets instead of three, with the Russell 1000 representing the largest 1,000 firms while small-cap firms are covered in the Russell 2000.

Much as we found with the parent indexes, the return performance of the subindexes is very similar to each other. The four large-cap indexes each have a correlation of more than 99% and the performance difference over the past 10 years is not statistically significant. As for the small-cap indexes, the S&P SmallCap 600 did have slightly better performance and lower risk than its three competitors over the past 10 years. But the volatility in the returns is so large as to make it difficult to declare a winner because the difference is not statistically significant. We prefer either Schwab U.S. Small-Cap ETF (SCHA) (expense ratio of 0.13%) or Vanguard Small Cap ETF (0.17%). Among the four, the Russell 2000 had the poorest performance.

There are a couple of reasons why this may have happened. One could argue that Russell is at a slight disadvantage in that it is giving purer exposure to riskier small caps rather than mixing in so many mid-cap names. The average market cap of a Russell 2000 company is $816 million, substantially below the $1,252 of the Dow Jones Small Cap Index. Because of its popularity among small-cap investment managers, Russell has a very large amount of passive money tied to it. The mechanical construction rules that the index follows means that many traders try to front-run and arbitrage index changes, hurting the performance of the index. Russell uses liberal inclusion rules, which have a bigger impact on smaller-cap companies where financial viability and quality are perhaps more important. For example, nearly 42% of the companies in the Russell 2000 had negative retained earnings, compared with 31% for the S&P 600. Russell also has a slightly higher weight in the poor-performing financial sector. Regardless, institutions that want to quickly move million-dollar blocks into and out of small caps will continue to use iShares Russell 2000 Index (IWM).

Other Subindexes

The index providers break down and combine their products in more ways than just large-, mid- and small cap. In a future article on the value and growth style subindexes, we will discuss how the index providers define value and growth and see that there are greater differences between index providers as we move to the corners of the Morningstar Style Box.

Float Adjustment

The two primary uses of indexes, economic research and investment performance measurement, can have conflicting requirements for index design. Economic researchers might use an index to study household wealth or to gauge the health of the economy. For example, the S&P 500 is one of 10 components in The Conference Board Leading Economic Index. Economic researchers would prefer an all-encompassing definition of an index. The other use is as a guide for investment, either to be replicated directly or as a benchmark for other investments. When used this way, it is important that the benchmark be investable - after all, it would be unfair to judge a portfolio manager against a group of stocks if she could not actually buy those stocks. This is the rationale behind using float-adjusted shares rather than the total shares outstanding. Certain holdings such as cross-company investments or holdings by insiders are considered strategic in that these investors are unlikely to sell or make their shares available to the public.

Just as private companies are excluded from an index, companies with a limited float may be considered semi-private. The difficulty lies in interpreting what constitutes a strategic investment. An example of the strange stock behavior that can occur when only a limited float of a company exists occurred during the height of the tech bubble, when 3Com floated 5% of Palm. The demand for shares of Palm was so strong that Palm became worth more than 3Com, despite the fact that 3Com still owned 95% of Palm, implying a negative value for the remainder of 3Com. Wal-Mart (WMT) has about 3.5 billion shares outstanding, but only about 1.8 billion are considered as float shares, because the Walton family controls 1.7 billion shares. So while Wal-Mart is about the 24th-largest company in the S&P 500 based on float shares, it could be as high as the sixth-largest company based on total shares. S&P has the most stringent float requirement; it requires that at least 50% of a company's stock floats to qualify for inclusion in their index, while Russell has the least stringent, requiring just 5%.

Rebalancing

Indexes are generally rebalanced as needed and reconstituted annually or semiannually. A rebalance is an opportunity to change share weights because of corporate actions. A reconstitution is a more complete readjustment, where stocks can move from one size segment index to another. For example, a mid-cap that has grown in size might become a large cap while a small cap that has fallen in size might be replaced. Russell, MSCI and Dow Jones use buffer zones to damp the likelihood that a stock near a market-cap breakpoint will bounce back and forth into different market-cap indexes as it rises in size into the next bucket only to fall back the next year.

While this reduces unnecessary turnover by index fund managers, it may reduce the integrity of the market-cap break-point definitions. Russell, MSCI and Dow Jones tend to follow their index rules mechanically while S&P views them more as guidelines and relies on an index committee to make final decisions. S&P reconstitutes its index on an as-needed basis rather than on a set calendar. Whereas the other index providers rank firms based on size without regard to industry, S&P claims that it attempts to make the industry composition of its indexes representative of the economy. In determining index constituents, S&P also takes into consideration financial viability criteria, but again these criteria are applied somewhat subjectively. For example, General Motors (GM) was not removed from the S&P 500 Index until after it declared bankruptcy, despite the fact that it clearly failed the financial-viability criteria and had become a small-cap company long before then. The criteria for eligibility for inclusion in an index are typically stricter than the criteria for removal from the index. Despite emerging from bankruptcy, General Motors has still not been included in the S&P 500.

Source: Indexing And ETFs