Index Funds: Made from Concentrate

re large cap U.S. equity index funds really all that different? Let's consider three well known index funds: Vanguard Index 500, Schwab 1000, and Vanguard Total Stock Index. As a reminder, the Vanguard Index 500 seeks to replicate the performance of the Standard & Poor's 500 Index, an index dominated by large cap U.S. stocks. The Schwab 1000 mimics the Schwab 1000 Index, an index consisting of the largest 1000 publicly traded U.S. companies. Finally, the Vanguard Total Stock Index seeks to replicate the aggregate performance of the Wilshire 5000 Total Stock Index, an index which consists of all U.S. stocks traded regularly in the NYSE, AMEX and OTC.

Consider the annual returns of the three funds over the past 8 years. As shown by the similar return patterns in Figure 1, these three index funds clearly have a common performance history. Nevertheless, they represent indices which are vastly different in terms of the number of holdings. Vanguard Index 500 holds positions in close to 500 stocks at all times. Schwab's portfolio is always near 1000 holdings, and Vanguard Total Stock Index tends to have around 3,500 holdings (a representative sample of the 5000 stocks in the Wilshire index).

Figure 1. Annual Returns of Large Cap U.S. Equity Indices

As seen in Figure 2, the differences in the number of holdings affect the median market capitalization of each index fund. The market cap differential between each fund has been quite consistent over the past 8 years, suggesting that each index taps into non-identical parts of the U.S. equity market pie. Moreover, the median market cap differences between each index have been quite stable in recent years.

The median market capitalization is described by Morningstar as follows:

"The median market capitalization of a fund's equity portfolio gives you a measure of the size of the companies in which the fund invests. It is the trimmed mean of the market capitalizations of the stocks in the fund's portfolio.

In computing the trimmed mean, Morningstar first ranks the common stocks (domestic and international) in a fund's portfolio from highest to lowest based on their market capitalizations. (The market capitalization of a stock is equal to the number of shares outstanding multiplied by the current price of the stock.) Then, we divide the list into five segments, the first quintile representing the top 20% of equity assets, the second quintile encompassing the next 20% of equity assets, and so on. Finally, we identify the stocks that fall into the third (middle) quintile of the portfolio, and we calculate the average-weighted market capitalization of the stocks in this middle quintile. The result is the median market cap.

Based on its September 1998 holdings, the Fidelity Magellan fund had a median market capitalization (MMC) figure of $65,206.89 (in millions). This was calculated by taking the capitalization figures for all US stocks with capitalization amounts greater than zero held by the fund. These securities, 310 for this fund, are sorted by their capitalization amounts. When sorted in descending order, the capitalization amounts (in millions) range from a high of $378,834 for Microsoft to a low of $55.68 for Alliance Gaming. The proportion each security makes up of the fund's overall US stock investment amount is then calculated. It is the securities within the mid-quintile, those that account for the 40-60% of the fund's US stock investment amount, that are weighted to determine the fund's MMC."

Each of these major indices shares a common piece of the "pie", but as the number of portfolio holdings increases more of the pie is subsumed. The common piece of pie shared by each index fund is, for all practical purposes, the S&P 500. So, each fund starts with a relatively common core. The Schwab 1000 fund then adds about 500 more securities and the Vanguard Total Stock Index adds about 3,000 more funds onto common S&P 500 "base".

As there is a finite supply of large cap U.S. stocks, an index (or index fund) which increases its number of holdings will drive down the median market cap of the portfolio as the list of large cap stocks is exhausted and mid cap and small cap companies are added. In theory, this would affect performance due to the fact that large, mid, and small cap stocks do not perform in perfect harmony. However, a major differential in performance has not been observed among these three major U.S. equity indexes. Why?

Figure 2. The "Cap" Comparison

The answer, in a word, is concentration. The three large cap indices (and hence the index funds which mirror them) being examined here all have portfolios which are market-weighted, meaning that larger companies are more heavily weighted in the portfolio. As seen in Figure 3, this leads to a "concentration" effect in which the three index funds have a large percentage of their holdings in the same large companies. So, despite portfolios which are vastly different in terms of number of holdings and moderately different in terms of median market cap, the performance of these three indices is surprisingly similar - precisely because the number of companies which are really driving the overall fund returns are relatively few in number and very similar within each fund. For instance, the top 10 holdings in the Vanguard Index 500 fund represent 25% of the entire fund's assets. The Schwab 1000 fund has the same ten funds as its largest holdings, which represent 22% of total net assets. The Vanguard Total Stock Index has 9 of the same 10 stocks as its top 10 holdings and despite a portfolio of nearly 3,500 stocks the largest 10 holdings represent 20% of the total net assets.

Between the Vanguard Index 500 and the Schwab 1000 22 of the top 25 holdings are the same, though having a slightly different weighting. Nineteen out of the top 25 holdings are identical between Vanguard Index 500 and Vanguard Total Stock Index. The largest 25 holdings (i.e. largest 5%) in Vanguard Index 500 account for 41% of the total fund assets. The largest 25 holdings account for 36% of Schwab 1000 net assets, despite representing less than 3% of the funds total number of holdings. The largest 25 holdings in Vanguard Total Stock Index represent less than 1% of the funds holdings yet comprise one-third of the fund's net assets. These indices are different yes, but not at the concentrated top. And it's from the concentrated top that the portfolio's return is primarily generated.

This concentration effect shows up in two important portfolio measurements, price/earnings ratio and price/book ratio. Notice in Figures 4 and 5 how similar these ratios are among these three index funds over the past eight years.

Funds (index or otherwise) may have different median market cap and large variation in total number of holdings, but if the portfolio P/E and P/B ratios are comparable over time it's highly likely that the funds in question are not freshly squeezed, but rather made from the same concentrate. As such, the likelihood for portfolio overlap (i.e. redundancy) is potentially very high among U.S. large cap indicies and the funds that clone them.

Bottom line: differences in the median market cap and the total number of holdings in different index funds can lead us to believe that they are markedly different. This, however, is not likely the case. Remember that portfolios which are market-value weighted, and which share a common concentrated base of stocks, will very often generate comparable returns. Such a result will be contrary to the objectives of diversification which prompted the use of several ostensibly different index funds. Thus, when indexing the large cap U.S. equity market, it may only require one fund to get the job done.

Figure 3. A Bit Top Heavy?

Figure 4. Price to Earnings Ratio

Figure 5. Price to Book Ratio