Comparing Apples to Apples By: Gabriel PotterMBA, AIFA® 2015.02.25
In October 2012, Vanguard – the largest provider of passive index funds – changed the focus from the MSCI indices to the relatively unknown FTSE and CRSP indices.  Within investment circles, the change was largely met with indifference.  After all, Vanguard had previously eschewed the industry standards (Russell and S&P indices) and followed the less popular MSCI indices to keep costs down.   The 2012 switch from MSCI to the FTSE & CRSP indices looked like similar behavior, completely consistent with Vanguard’s modus operandi. 

Competition within the razor thin profit margins of passive investment is based upon keeping costs down.  The methodologies for the large index designers are generally pretty similar, so why pay more for the more expensive industry standard? 

This raises the question:  how similar are the indices?  There are all sorts of slight variations in methodology, but do they make a difference?  We ask this question become performance for some Vanguard products have started to sharply deviate from the classic industry standard indices. 

For example, the Vanguard Small Cap Index Fund (VSMAX) returned about 7.50% in 2014.  In contrast, the industry standard – the Russell 2000 – returned only 4.89% in 2014.  I’m sure investors aren’t complaining about 2.6% of outperformance, but they might be confused.  Passive investments, after all, are supposed to trail their index.  Here’s a similar example, except this one involves underperformance:   the Northern Mid Cap Index Fund (NOMIX) returned 9.6% in 2014, but the Russell Mid Cap index returned 13.22%.

For clarity – let’s look at the actual returns for 3 sets of indices:  Russell, S&P and CRSP.


Some key observations:

Larger indices correlate more strongly than small cap indices.  That makes sense.  Everyone can agree where the starting point in a market weighted index is – the largest company.  So, take the largest companies and include as many as you like to make a market index.  The question is whether you stop at the top 1000 or top 500 companies.  This makes the beginning and end points for medium and small cap companies vary significantly.     (Mind you, the methodologies are more complex for different indices which are selected, like S&P indices, rather than merely calculated.) 

Our faithful readers will have read our most recent article on the Death of Active Management where we detailed the differences in performance along different average capitalizations.  This has made a significant difference to index performance this year.  To be specific, the Vanguard Small Cap index fund (which follows the CRSP index) has an average market cap of $2.94 billion.  By comparison, the Russell 2000 index goes for much smaller positions and has a average market  cap of $1.49 billion.  In other words, the CRSP index looks like a blend of medium and small size businesses if you use look through Russell’s benchmarking system.  This, essentially, is why the Vanguard index is clobbering the Russell index right now. 

Similarly, the Northern Mid Cap index fund is matching the market capitalization of its target, the S&P 400 mid cap index.  The S&P 400 index has a weighed market cap of $4.5 billion, but the Russell Mid cap index is substantially higher at $10 billion.  Again, large caps are beating small caps.  Russell has larger companies in it – so it’s beating the S&P and, by proxy, the Northern Mid cap index.  Some differences tend to mellow out and equalize in the long term.  Look at the S&P Mid-Cap indices, which significantly trailed peers over the past few years, but actually have a very minor edge in the 10 year value.

Gabriel Potter

Gabriel is a Senior Investment Research Associate at Westminster Consulting, where he is responsible for designing strategic asset allocations and conducts proprietary market research.

An avid writer, Gabriel manages the firm’s blog and has been published in the Journal of Compensation and Benefits,...

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