Looking Beyond Cap-Weighted Indexes

Reprinted from Financial Planning Magazine, May 2008
Craig L. Israelsen, Ph.D.

ear markets sometimes occur without widespread awareness. The year 2007 may have been one of those years. The performance of US stocks in 2007 resembled, to a surprising degree, the performance of stocks in 2000-a year widely perceived as a bear market.

In 2000, the average US stock had a return of -5.1%, while in 2007 the average stock return was -3.2%. Median returns were nearly identical in both years (-13.8% vs. -13.3%), as were share-weighted returns (-1.5% vs. -1.6%). In both years, about 60% of all stocks had a negative return. The difference between 2000 and 2007 is this: mega cap stocks did badly in 2000 (i.e., S&P 100 Index lost 12.6%) whereas in 2007 mega cap stocks did OK (DJIA up 8.9%, S&P 100 gained 6.1%).

Let's now examine the performance of the US equity market from the perspective of prominent capitalization-weighted equity indexes. Market capitalization is the product of number of outstanding shares and price per share.

A Mixed Year for US Equities

As you look at the returns of prominent US equity indexes in 2007 (see pink shading in "Equity Index Lineup"), they generally present a picture of modest performance. Lurking under the aggregate indexes is a different reality as suggested by the 2007 return of the equal-weighted Dow Jones Wilshire 5000 Equal Weighted Index (-6.7%).

Digging deeper we discover that the mean equal-weighted, one-year return for all 6,342 stocks in the Morningstar database during 2007 was -3.2%, while the median return was -13.3%. A median return below the mean return reveals broad weakness that is often hidden by tip-of-the-iceberg cap-weighted indexes.

In fact, nearly 64% of all 6,342 individual securities in the Morningstar database (see "Individual U.S. Equities") had a negative return in 2007. The mean equal-weighted return for the 4,053 stocks with a negative return was -36.8%, while the median negative return was -31.1%.\

But, the glass is not entirely half empty. There were 2,289 individual stocks that had a positive return in 2007. The average positive return was 56.3% and the median positive return was 26.7%. These results represent the returns of all 2,289 stocks being equally-weighted. But, nearly all prominent equity indexes are capitalization weighted, therefore I share-weighted the returns of all 6,342 stocks to create a performance figure analogous to market-cap weighting. The share-weighted return of all U.S. stocks in 2007 was -1.6%. By comparison, in 2006 the share-weighted return of all stocks was 18.5%. That the share-weighted return (-1.6%) was higher than the equal-weighted mean return (-3.2%) suggests that larger stocks (as measured by outstanding shares) tended to perform better than small stocks in 2007.

In fact, the share-weighted return for US stocks in 2007 (-1.6%) was basically the same as in 2000 (-1.5%). Interestingly, several other equity performance measures in 2007 (mean return, median return, percentage of stocks with negative return) are quite similar to the same measures in 2000. And yet, based on the performance of prominent indexes, 2000 and 2007 don't look similar at all…except for the equal-weighted DJ Wilshire 5000.

U.S. Equity Index Lineup

Annual % Returns of Major U.S. Equity Indexes	1999	2000	2001	2002	2003	2004	2005	2006	2007
DJIA	27.2	-4.9	-5.4	-15.0	28.3	5.3	1.7	19.1	8.9
S&P 100	32.8	-12.6	-13.8	-22.6	26.2	6.4	1.4	18.5	6.1
S&P 500	21.0	-9.1	-11.9	-22.1	28.7	10.9	4.9	15.8	5.5
Russell 1000	20.9	-7.8	-12.5	-21.7	29.9	11.4	6.3	15.5	5.8
Russell 2000	21.3	-3.0	2.5	-20.5	47.3	18.3	4.6	18.4	-1.6
Russell 3000	20.9	-7.5	-11.5	-21.5	31.1	12.0	6.1	15.7	5.1
DJ Wilshire 5000 (cap-weighted)	23.6	-10.9	-11.0	-20.9	31.6	12.5	6.3	16.0	5.7
DJ Wilshire 5000 (equal-weighted)	38.4	-7.5	27.9	-9.5	91.8	28.9	5.5	18.9	-6.7

Source: Morningstar Principia raw data

US Equity Mutual Funds

Next, let's examine U.S. equity mutual funds (see "U.S. Equity Funds"). There were 2,691 U.S. equity funds that survived the entire year of 2007. Only domestic equity funds with at least 12 months of performance as of 12/31/2007 were included in this analysis. Furthermore, funds with more than 15% of their portfolios in cash, bonds or non-U.S. stock were removed from the study. Redundant share classes were also omitted. These filters allow for a more sensible comparison with the performance results of individual U.S. stocks.

The mean equal-weighted one-year return of U.S. equity funds in 2007 was 5.4%, while the median return was 5.2%. The asset-weighted one-year return (a figure I calculate by weighting each fund's one-year return by its percentage of the total fund assets of all 2,691 funds) was 6.3%. As with stocks, this suggests that larger funds (i.e., funds with more assets) performed slightly better than funds with small asset bases-or, that by year-end the better performing funds had attracted proportionally more assets. I suspect the former is the more likely explanation.

There were 720 funds-nearly 27% of the group-that had a negative one-year return in 2007. The average negative return of those funds was -7.1%, while the average return of the 1,971 funds with a positive return was 10.0%. The best performing U.S. equity fund in 2007 generated a total return of 55.2% (Fidelity Select Energy) while the worst performing fund had a return of -58.0% (iShares Dow Jones US Home).

Stocks vs. Funds

As shown in "Performance of Survivors", 55% of all the stocks that survived the three-year period ending 12/31/2007 had a negative 3-year annualized return. By comparison, less than 2% of all mutual funds that survived the full three-year period had a negative return. The average 3-year equal-weighted return of all stocks was -5.2% compared to 8.5% for all US equity mutual funds (also an equal-weighted figure).

Investing in a fund rather than a single stock usually leads to a better outcome. However, you'll notice that in 2002 just over 97% of all mutual funds had a negative return compared to 63% of individual stocks with a negative one-year return. Occasionally the protection offered by a portfolio disappears. More on that in a moment.

Over the past five year period (ending 12/31/07), nearly one-third of all surviving stocks had a negative 5-year annualized return. By comparison, less than 1% of all US equity funds had a negative 5-year annualized return over the period from Jan 2003 through Dec 2007. The average return for all stocks was 7.9% and 14.2% for US equity funds.

Finally, over the 10-year period from January 1998 to December 2007, 40% of all surviving stocks had a negative return compared to only 1% of all funds. The average 10-year annualized return for surviving stocks was -1.0% while the average 10-year return for US equity funds was 7.2%.

Returns by Style Box

The year 2007 was clearly the year for growth stocks, and the larger the better. As shown in "By the Box", the average large cap (LG) growth stock (as categorized by Morningstar) had a one-year return of over 40%. Mid cap growth stocks (MG) performed similarly, while small cap growth (SG) stocks averaged about a 30% return.

Growth oriented US equity funds (large cap and mid cap) averaged about 12-13% in 2007, while small cap growth funds averaged a 7% one-year return. If you were a value-oriented investor in 2007, you did "less bad" in the average value fund than in the average value stock.

Conclusions

The US equity "market" is typically measured by the performance of prominent market-cap weighted indexes. Thus, if the largest and most popular stocks do well, the prominent equity indexes do well. Such was the case in 2007, but not in 2000. This is precisely why over half of all US equity mutual funds had a negative return in 2000. Most mutual funds end up buying the same large cap stocks and in 2000 that didn't work out well. In 2007, despite nearly two-thirds of all US stocks having a negative return, the largest stocks in the US market did OK-and as a result most US equity funds did OK.

Bottom line: the performance of most US equity mutual funds tend to mimic the performance of prominent market-cap weighted indexes (see "Cap-Weighted Club"). If your client has a market cap weighted portfolio he or she will have an investment experience that is similar to most of the prominent indexes. If they don't, they won't (as shown by the yellow bars). Now you can help them understand why.

Individual U.S. Equities

US Stocks	1999	2000	2001	2002	2003	2004	2005	2006	2007
Number of Stocks in existence the full year	6,242	6,090	6,197	6,004	5,758	4,952	6,091	6,133	6,342
Mean % One-Year Return  (equal-weighted)	42.7	-5.1	18.1	-11.5	86.9	24.0	7.1	17.5	-3.2
Median % One-Year Return	-3.9	-13.8	3.5	-14.4	42.4	14.3	-1.3	8.4	-13.3
Share-Weighted One-Year % Return	41.7	-1.5	-3.1	-26.0	57.8	13.8	2.9	18.5	-1.6
Number of Stocks with Negative Return	3,384	3,648	2,904	3,763	866	1,635	3,199	2,414	4,053
Percentage with Negative Return	54.2	59.9	46.9	62.7	15.0	33.0	52.5	39.4	63.9
Average Negative One-Year % Return	-29.7	-47.9	-41.9	-44.2	-33.4	-24.9	-30.6	-30.5	-36.8

Sources: Morningstar Principia raw data

U.S. Equity Funds

US Equity Funds	1999	2000	2001	2002	2003	2004	2005	2006	2007
Number of Funds in existence the full year	1,971	2,018	2,317	2,391	2,584	2,592	2,536	2,637	2,691
Mean % One-Year Return (equal-weighted)	28.4	-0.3	-10.9	-22.8	34.0	12.8	6.9	13.2	5.4
Median % One-Year Return	19.6	-2.0	-11.9	-22.5	31.1	12.0	6.4	13.4	5.2
Asset-Weighted One Year % Return	29.2	-5.0	-11.8	-21.4	31.4	12.5	7.0	14.4	6.3
Number of Funds with Negative Return	268	1,096	1,787	2,322	8	49	162	55	720
Percentage of Funds with Negative Return	13.6	54.3	77.1	97.1	0.3	1.9	6.4	2.1	26.8
Average Negative One-Year % Return	-5.8	-13.8	-17.4	-23.6	-10.0	-5.0	-3.7	-2.4	-7.1

Sources: Morningstar Principia raw data

Performance of Survivors (as of 12/31/07)

	All Stocks*		All US Equity Funds*
	Percentage with Negative Return	Mean Annualized Return %	Percentage with Negative Return	Mean Annualized Return %
3-Year Period (2005-2007)	55.3	-5.2	1.6	8.5
5-Year Period (2003-2007)	32.1	7.9	0.3	14.2
10-Year Period (1998-2007)	40.0	-1.0	1.0	7.2

*Only measuring stocks and mutual funds that were in existence the entire time frame ending December 31, 2007

By the Box

Cap-Weighted Club

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Craig L. Israelsen, Ph.D. teaches family finance at Brigham Young University. He is a principal at Target Date Analytics LLC (www.TDBench.com) and author of "7Twelve", a guide to building diversified, multi-asset portfolios. To purchase a copy of 7Twelve, send an email to Jim Eccleston at jeccleston@snsfe-law.com.