Let’s explore an aspect of index investing that is often overlooked—the index fund’s benchmark.
People talk about investing in the “market,” but what does that really mean?
When the media says the market was up or down, they are generally referring to the Dow Jones Industrial Average (DJIA), the S&P 500 Index, or the NASDAQ Composite Index. These three measures are all heavily tilted toward large U.S. companies.
Yet the market is composed of thousands of stocks, bonds, and other securities for which there is really no holistic measure.
Not only is there no holistic measure for the market, even specific asset class categories (e.g., domestic small company stock, government bonds, etc.) have competing indices that track the category in different ways.
Index Investing—Pick Your Benchmark
If you believe in passive-management (i.e., index fund investing), this is important. The index funds used to construct a passive portfolio are generally managed to mimic the performance of an index.
The index is referred to as the fund’s benchmark.
The best choice for a given asset category can depend on how the index is constructed. And which securities happened to outperform and how these securities are weighted in the index.
One index might perform better over one time period, and another index tracking the same category, outperform the next.
Small Company Indices: An Illustration
To illustrate this point, let’s focus on small-cap U.S. stocks and the indices commonly used to track this category.
We researched five different indices which are used as benchmarks: the Russell 2000, the S&P Small Cap 600, Russell RAFI US Small Company Index, CRSP US Small Cap and the MSCI US Small Cap 1750.
U.S. Small-Cap Index Returns
Source: Vanguard.com; FTSERussel.com. As of 4/30/2023.
Of these, the two most common tracking indices are the Russell 2000 and the S&P Small Cap 600 index.
Note that the annualized 5-year return is over 1% higher for the S&P Small Cap 600 index.
Of course, there is no guarantee the S&P small cap index will continue to outperform the Russell 2000 index.
The MSCI US Small Cap 1750 index posted an even better 5-year performance. Besting the Russell 2000 Index by 2% annual.
But the best cap-weighted index over the past 5-years, has been the CRSP US Small Cap Index. This index posted a 6.4% 5-year average return. In addition, it has the smallest loss at -2.4% over the past 12 months.
Vanguard’s small cap index funds (e.g., VSCIX | Small-Cap Index Fund Institutional Shares) have switched benchmark over the years. They tracked the Russell 2000 Index through May 16, 2003; MSCI US Small Cap 1750 Index through January 30, 2013; and the CRSP US Small Cap Index thereafter.
Non-Traditional Indices
To further complicate matters, funds have been introduced that don’t track traditional capitalization weighted indices like the S&P 500 and Russell 2000.
Some of these track “fundamental” indices which weight stocks by their “economic footprint” instead of market size (capitalization). Factors used to determine the economic footprint include sales, cash flow, dividends, and book value.
The Schwab Fundamental US Small Company Index (SFSNX) fund is one example; it tracks a Research Affiliates Fundamental Index (the Russell RAFI US Small Company Index).
Over the past 5 years, this index has beaten all of these cap-weighted small-cap indices. Plus, its 1-year performance is the best among the five indices, yet still negative.
The DFA Approach
Finally, there are mutual funds from Dimensional Fund Advisors (DFA), which are popular with many financial advisors.
These funds employ a passive investment approach similar to index investing, but don’t track a specific index.
The DFA US Small Cap I (DFSTX) fund, as of 4/30/2023, posted a 1-year return of 0.4% and a 5-year annualized return of 6.2%.
Netting a 1-year return significantly above the indices and the only one with a positive return.
For the 5-year period, the return is equal to the MSCI US Small Cap 1750, and up to ~200 basis points better than the more popular benchmarks.
