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One Market, Many Performances
by Craig L. Israelsen
University of Missouri-Columbia
From Financial Planning Magazine, November 2000. Reprinted with permission.
or faint hearted investors, the 2nd quarter of 2000 was an unpleasant adventure. The S&P 500 was down almost 3% and the Wilshire 4500 (a small & mid cap index composed of the Wilshire 5000 minus the S&P 500 stocks) was off nearly 9.5 percent. Indeed, as shown in Figure 1, the 3 months from April through June were a meltdown for most U.S. equity indexes. During the first 6 months of 2000 the S&P 400 (a mid-cap index) was up 9% and the Russell 2000 (a small cap index) was up 3% despite small losses in the S&P 500 Index and the Wilshire 4500 Index. In contrast, the month of June was a banner period for the Wilshire 4500 but not the S&P 400.
The stock market is somewhat like the weather - it's unpredictable and spotty. Just because it's raining in one part of town doesn't mean it's raining in the entire town. In like manner, just because one market index is doing well does not guarantee that all equity indexes will follow suit. The differing patterns of return of market indexes also serve as a reminder as to the value of diversification.
The U.S. equity market is too broad to be mirrored solely by one index. Any serious attempt to invest in "the market" will require the use of several indexes. While the S&P is by far the most popular equity index to mimic, most major equity indexes are mirrored by at least several mutual funds. As one example, the Vanguard Group has funds which mirror each of the four major indexes shown in Figure 1.
U.S. Equity Index Vanguard Fund
| S&P 500 |
Vanguard 500 Index |
| S&P Mid-Cap 400 |
Vanguard Mid Cap Index |
| Wilshire 4500 |
Vanguard Extended Market Index |
| Russell 2000 |
Vanguard Small Cap Index |
Equity mutual funds, within the Morningstar Principia Pro database, are assigned a "best-fit" equity index. The four most common are the S&P 500, S&P 400 Midcap, the Wilshire 4500, and the Russell 2000. The term best-fit makes reference to the statistical correlation between the performance of a benchmark index and a particular fund. As of June 30, 2000 there were 886 domestic equity funds which had the S&P 500 as their best-fit index. These are not index funds, but rather managed equity portfolios whose performance best matches that of the S&P 500 Index over the preceding 3 year period. In selecting funds for analysis in this study, only distinct portfolios with at least 3 years of performance data as of 6/30/00 were included. Moreover, index funds (i.e. portfolios specifically designed to mimic a particular index) were excluded.
Total return data for funds which have the S&P 500 as their best-fit index are shown in Figure 1, as are performance data for 272 equity funds which best-fit the S&P Midcap 400 Index, 460 funds linked to the Wilshire 4500 Index, and 153 funds which best-fit the Russell 2000 Index. It is interesting to note how disparate the returns of actual mutual funds (at the aggregate level) can be from their respective "best-fit" or benchmark index. The differential in return between indexes and the funds which "best-fit" them is presented in Figure 2. For instance, the S&P 500 return for the one year period ending in June 2000 was 7.25% while the average return for the 886 funds which best-fit the S&P 500 was 2.65%, or a differential of 460 basis points.
As demonstrated in Figure 2, the differential in return tends to increase when moving from large cap (S&P 500) to small cap (Wilshire 4500 and Russell 2000). This finding is consistent in the time frames which exceeded one month. This suggests that midcap and small cap indexes less accurately reflect the performance of the mid and small cap mutual funds. Said differently, compared to the S&P 500 Index, the other three indexes have more noise in them. Noise is a term which implies error.
One possible cause for noise, or error, between the performance of actual funds and their "best-fit" index is standard deviation of return (Figure 3). Regardless of time frame, standard deviation tends to be lowest among funds which best-fit the S&P 500, higher among funds tied to the S&P 400 Midcap index, and highest among funds which best-fit the small cap indexes (Wilshire 4500 and Russell 2000). Standard deviation, while not a perfect measure, is often used to assess risk. In short, the performance of mutual funds which focus on small stocks tends to be more volatile, not necessarily because of dramatically different management paradigms, but rather the erratic nature many small and midcap stocks.
For example, the standard deviation of return for funds which best fit the small cap indexes (Wilshire 4500 and Russell 2000) is consistently 1.5 to 2.5 times higher than the standard deviation of return for S&P 500 funds. Wide variations in return among "best-fit" funds will clearly lead to large discrepancies when comparing fund returns to a benchmark index. Clearly, the "fit" for funds which are assigned to the S&P 500 is generally better than the "fit" for funds which are benchmarked against the mid and small cap indexes.
Higher standard deviation of return, i.e. higher risk, isn't all bad. For example, from July 1999 to June 2000 the average return for the 886 funds which best-fit the S&P 500 Index was 2.65% whereas the "more risky" funds which best-fit the Wilshire 4500 Index had an average return of 51.51% -- nearly 20 times higher. The standard deviation of the Wilshire 4500 funds was 30.09, or almost 3 times larger than the standard deviation of 11.21 for the funds which best-fit the S&P 500. During this particular time period, the risk/return tradeoff clearly favored the small cap funds. Obviously, this will not always be the case. Indeed, the three months from April to June, 2000 presents the opposite picture when comparing the S&P 500 and Wilshire 4500.
To summarize, consider the following:
Measuring how "the market" is doing is entirely dependent upon which index you look at.
Actual performance of managed mutual funds can differ greatly from their "best-fit" index, as shown in Figure 4.
Different segments of "the market" (i.e. large cap, mid cap, small cap) often have different seasons of distress and success, suggesting that diversification across several indexes is prudent.
Proponents of the Capital Asset Pricing Model maintain that diversification within a portfolio of securities can typically remove most of the unsystematic risk, or the risk that is specific to an individual company. Systematic risk, on the other hand, is inherent within any equities market. A market is a system, and inside that system exists risk. Systematic risk is wide-scale risk in that it tends to affect securities in general, though in varying degree. Systematic risk is difficult to remove entirely. However, diversifying across different systems (large cap, mid cap, small cap, non U.S. stock, etc.) may reduce, or diffuse, systematic risk.
Attempting to describe how the stock market is performing can be likened to a person who asks a parent how his/her four children are doing? The general response of "Fine" is not very instructive. Only when the parent provides detail regarding each individual child does the person who inquired have useful information. It may, in fact, be the case that three of the children really are doing fine, whereas one child is struggling. With the child metaphor in mind, re-examine the three year data in Figure 1 for each of the four major indexes. Now re-examine the three year performance of the best-fit funds in Figure 1. Do you see the point? How the market (children) is doing is a function of which index (child) you inquire about. To complicate matters, when looking at the performance of funds which best-fit the different indexes the question of "how is the market doing?" Changes dramatically. So, how is the market doing?
Special thanks to Ramiro Sanchez for his assistance with this article.
Figure 1. Total Percentage Returns Through June, 2000
|
|
1 Month
June
|
3 Months
Apr-June
|
6 Months
Jan-June
|
1 Year
7/99-6/00
|
3 Years
7/97-6/00
|
S&P 500 Index 886
Best-Fit Funds (Ave)
|
2.47
.76
|
-2.66
-1.58
|
-.43
-.41
|
7.25
2.65
|
19.66
13.13
|
S&P 400 Midcap Index
272 Best-Fit Funds (Ave)
|
1.47
1.41
|
-3.29
-.47
|
8.97
5.72
|
16.97
7.02
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20.34
8.90
|
Wilshire 4500 Index
460 Best-Fit Funds (Ave)
|
11.18
12.61
|
-9.41
-6.84
|
-.41
7.14
|
21.19
51.51
|
18.56
31.27
|
Russell 2000 Index Return
153 Best-Fit Funds (Ave)
|
8.72
9.83
|
-3.78
.22
|
3.03
12.74
|
14.33
31.96
|
10.57
14.90
|
Figure 2. Differential in Return Between Funds and Indexes (in basis points)
|
|
1 Month
June
|
3 Months
Apr-June
|
6 Months
Jan-June
|
1 Year
7/99-6/00
|
3 Years
7/97-6/00
|
S&P 500 vs. 886 Fund Ave.
|
171
|
108
|
84
|
460
|
653
|
S&P 400 vs. 272 Fund Ave.
|
6
|
282
|
325
|
995
|
1,144
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Wilshire 4500 vs. 460 Fund Ave.
|
143
|
257
|
755
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3,032
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1,271
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Russell 2000 vs. 153 Fund Ave.
|
111
|
400
|
971
|
1,763
|
433
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Figure 3. Standard Deviation of Return (as of June 2000)
|
|
1 Month
June
|
3 Months
Apr - June
|
6 Months
Jan - June
|
1 Year
7/99 - 6/00
|
3 Years
7/97 - 6/00
|
886 S&P 500 Best-Fit Funds
|
3.71
|
3.10
|
4.93
|
11.21
|
7.16
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272 S&P 400 Best-Fit Funds
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3.33
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4.27
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7.21
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13.54
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8.11
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460 Best-Fit Wilshire 4500 Funds
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7.38
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5.74
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10.01
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30.09
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15.31
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153 Best-Fit Russell 2000 Funds
|
6.28
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7.31
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13.53
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28.43
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11.74
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Figure 4. Three Year Return: July 1997-June 2000
(Shaded portion of Figure 2 provide data for this graph)
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