By Rolf Agather, managing director, applied research at FTSE Russell
As the bull market marched on in 2019, rising markets continued to lift US stocks to new highs. Indexes are generally the metric for these milestones, which can at times raise questions about uneven performance—particularly when an index reaches an all-time high while another comparable index doesn’t. But comparisons such as these lose sight of the very purpose of a passive index, which is to stay true to its stated objectives rather than outperform them.
Let’s take, for example, two indexes designed to measure the US small cap equity market. While they might appear similar in name, they can be significantly different in composition. If these two indexes are constructed using a different set of rules, they can vary with respect to the nature and number of their constituents, which can result in distinctly different characteristics. For example, while both indexes might claim to be broad, passive representations of the US small cap equity market, one might be skewed more toward growth stocks than the other.
These types of differences can result in considerably different performance outcomes, which can raise questions as to why one “outperformed” the other—or why one reached an all-time high while the other fell short. But if we think about what indexes are intended to do, the question is not whether the index performed well, but whether it accurately represents the asset class it’s intended to measure. A well-designed index should stay consistent with stated objectives, and not drift in style or market capitalization.
In fact, when an index performs significantly better or worse than the broad market it’s designed to represent, it could be cause for concern. This is because any deviation from an objective representation of its stated asset class will create active bets in a fund designed to track the index. And an index designed to represent a passive investment should be just that—passive—otherwise it loses its suitability as an objective benchmark, or as the basis for a passively managed fund.
An objective and transparent index construction methodology can ensure an index consistently represents its intended market. For example, the Russell 1000 Value Index and Russell 1000 Growth Index are constructed to be distinctly growth or value, following a clearly defined set of rules and reconstituted on an annual basis to maintain alignment with those rules. The Russell 1000 Index is by definition not biased to a particular style, and is therefore designed not to drift from its stated objectives. As such, these indexes are constructed to stay true to their passive nature.
The below chart demonstrates how the Russell 1000 Value, Russell 1000 Growth and Russell 1000 Indexes are all designed true to their objectives. The Fama-French three-factor model is a well-known approach for explaining stock returns, and the High Minus Low (HML) factor within the model can be used to assess the value factor exposure of an individual stock or a portfolio. A value index should have a positive coefficient, or exposure, to the HML factor return, while a growth index should have a negative coefficient. As shown below, these three indexes have all demonstrated consistency with their stated objectives.
Source: FTSE Russell, data as of November 30, 2019. Past performance is no guarantee of future results. Please see the end for important legal disclosures.
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