By Catherine Yoshimoto, Director, Product Management,
The perils of ignoring the three benchmark principles
Benchmarks have a variety of uses and play an important role in every step of the investment process. Many investors use benchmarks to conduct risk analysis and to develop investment policies and strategies. And once these strategies are implemented, nearly all investors use benchmarks to evaluate the performance of their portfolios. Benchmarks also underlie trillions of dollars in passive investment products such as mutual funds or ETFs.
To effectively serve these purposes, we believe there are some universal design standards that every market-leading benchmark should follow. We identify three important principles that help define a good benchmark: objectivity, modularity, and reliability. Adhering to these principles is essential to a benchmark’s ability to represent a market or market segment—and ignoring them can compromise the very essence of what benchmarks are intended to do.
Principle 1: Objectivity and accuracy
For a benchmark to deliver an unbiased, complete view of the market it’s designed to represent, it’s important that the index provider select its constituents with objectivity. This means the index should be constructed with a disciplined, systematic approach that doesn’t require any exceptional knowledge of the market or its constituents.
All benchmarks aren’t equal in this regard. For example, the Russell 1000 Index and the S&P 500 Index are both widely used benchmarks of large capitalization US stocks, but their construction methodologies differ. One key difference is the Russell 1000 is fully reconstituted each June and market capitalization breakpoints are reset, while the S&P 500 Index ranges are reviewed on occasion with no regularly scheduled reconstitution process.
Differing approaches to constituent selection can have a significant impact on benchmark composition. As shown below, several noteworthy US large cap stocks that are included in the Russell 1000 index are excluded from the S&P 500 Index.
Source: FTSE Russell. The market capitalization breakpoints, constituents and total market cap above are for the Russell 3000 Index as of reconstitution rank day in May. The market capitalization breakpoints for the Russell US Indexes are based on new additions as of reconstitution. The market capitalization ranges used above are absolute breakpoints for new members and do not include capitalization banding. Capitalization banding involves the implementation of a ±2.5% band around certain breakpoints. For further information, please refer to the Russell US indexes construction and methodology document or contact FTSE Russell Client Service. S&P source: iShares S&P 500, 400, 600 ETF holdings https://www.ishares.com/us/; S&P index methodology http://www.standardandpoors.com/indices. Data as of May 7, 2021.
Unsurprisingly, these differences in coverage can have a significant impact on the performance of the respective benchmarks—particularly when it comes to some tech and innovation companies with rapidly growing market capitalizations.
Principle 2: Modularity
A second important benchmark construction principle is modularity. By this we mean that the broad market index is segmented into modular components—or building blocks—that investors can use separately or in combination to build a portfolio that best fits their objectives.
For example, we segment the Russell 3000 Index into different, modular market cap indexes. The Russell 1000 consists of the largest 1,000 stocks (by capitalization) in the Russell 3000 Index and the Russell 2000 consists of the remaining 2,000 names. The Russell 3000E Index is then divided into additional market cap segments to create the entire series of Russell US Indexes.
Not all benchmark families follow the same principle of modularity. For example, the S&P Composite 1500 index can be subdivided into the S&P 500 index of large cap stocks, the S&P MidCap 400 index and the S&P 600 SmallCap index. But while the indexes have target market capitalization ranges that don’t overlap, as shown below the actual market cap ranges of the stocks in the three indexes do overlap.
A lack of modularity can produce inadvertent exposures and undermine the intended asset allocation goal. For example, if the lines between small and large cap market segments are blurred, an investor using separate indexes to allocate assets between the two categories may end up with unnecessary overlap.
Source: FTSE Russell. As of Russell US index reconstitution rank day May 7, 2021. The market capitalization breakpoints for the Russell US Indexes are based on new additions as of reconstitution. The market capitalization ranges used above are absolute breakpoints for new members and do not include capitalization banding. Capitalization banding involves the implementation of a ±2.5% band around certain breakpoints. For further information, please refer to the Russell US Indexes construction and methodology document or contact FTSE Russell Client Service.
S&P source: iShares S&P 500, 400, 600 ETF holdings https://www.ishares.com/us/; S&P index methodology http://www.standardandpoors.com/indices. Data as of May 7, 2021.
This may contribute to performance differences that may cause unintended bets on the wrong size segment. For example, over the last six quarters, the return of the Russell Midcap index landed between the large and small cap index segments each quarter, however this was not the case with S&P’s size indexes.
Principle 3: Reliability
It’s critical for an index to have a disciplined, reliable maintenance process in place that’s backed by a well-defined, balanced governance system. The market is constantly changing as new companies are listed, existing firms are acquired, and companies grow to reach new size segments.
To ensure we’re staying abreast of these changes, the Russell US indexes employ a regularly scheduled series of objective, disciplined maintenance processes that not only include our annual reconstitution, but also quarterly additions of IPOs and as-needed adjustments due to corporate actions. Indexes that lack the maintenance protocols necessary to reflect market changes in a timely manner tend to have unintended sector and/or capitalization biases.
Ensuring exposure to the true opportunity set
A benchmark is only useful to the extent that it accurately reflects the market it’s intended to represent. These three principles can be useful for investors evaluating whether an index represents the true opportunity set—and in turn, whether it can serve its purpose as an effective benchmark.
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