Tag Archives: S&P 500

Index Mix & Match? I think not! (05/08/2014)

Last time we looked at Broad Market index options. If you thought that was confusing, wait till we look at the landscape for ETFs based on company size. Let’s say you want to overweight mid and small cap because you have learned that they outperform large caps over the long run (albeit with increased risk). Besides, you want to be able to see the underlying portfolio blocks and rebalance between categories.

CRSP (Vanguard’s index provider) has done a great job describing various ways to split the market into size groups. Basically, you can slice the total market into either Two-Tier: Large + Small or Three-Tier: Large + Mid + Small. Of course ever-obliging ETF providers responded to investor demand by offering midcap options for even two-tier indexes. This and the sheer number of market cap ETFs created a confusing mess that we’ll attempt to decipher below.

Introducing the Field

Exhibit 1 shows available index funds with important characteristics to compare them. I described the metrics in the Broad Market Index post but also added Annual Turnover % as a proxy for tax-efficiency and other hidden costs. Naturally, broad index funds have the lowest turnover while small and midcap ones make a lot of portfolio changes due to fluid nature of those categories. I also calculated the stats for a sample combination of large & small indexes for each family. This way you can compare the resulting portfolio to the corresponding total market fund.

Exhibit 1 – Major Family Index Offerings by Market Cap


Exhibit 2 puts the same line-up into visual form to see how they jive together. It is built to scale based on a number of holdings in each ETF (3,500 being the highest – so we have 35 “notches” of 100 stocks each). One caveat is that the number of companies in the fund doesn’t reflect its true diversification. For example, ITOT’s 1,500 holdings is only 40% of VTI’s 3,700 stocks yet it covers approximately 90% of the U.S. market capitalization.

Exhibit 2 – Market Cap Combinations


Now, let’s review the line-up for each family.

Vanguard – CRSP US Total Market Index

Vanguard fields four market cap funds. CRSP describes this combined logic on their website:

The combined-size approach constructs indexes that function effectively in both building block scenarios. For the two-tier approach, an investor can combine CRSP Large + CRSP Small, or if a three-tier approach is preferred, the investor can use CRSP Mega + CRSP Mid + CRSP Small.

The one potential point of caution: If investors combine CRSP Large + CRSP Mid + CRSP Small, they have an overweight position in mid-cap stocks since large is already made up of Mega + Mid.

This point in bold is very important. I have seen this combination in quite a few portfolios. Let’s say if your goal was to overweight smaller companies and you allocated 60% to large, 25% to mid and 15% to small cap Vanguard funds. The resulting portfolio would double up on midcaps and actually be 55% large, 37% mid and only 8% small.

Note that Vanguard’s high turnover ratio has to do with them switching from MSCI to CRSP benchmark in 2013 and it should be lower in the future.

Schwab – Dow Jones U.S. Broad Stock Market Index

This is a solid offering, but once again you have to be careful with midcap component (Exhibit 2). It actually overlaps both large and small funds and is not necessary to create a total market portfolio. At my firm we typically use 75% SCHX / 25% SCHA for domestic equity – it’s very cheap (5 basis points for the combo), funds are very sensibly constructed and there are no transaction costs at Schwab.

iShares – Russell Index

Despite being the most expensive option, this is another popular stable of funds with great market coverage. Midcap fund is once more superfluous and completely overlaps with Russell 1000. Unique to this line-up, Russell offers a micro-cap option if you are interested in the very smallest public companies out there. Be careful though as IWC has a high expense ratio and can run into liquidity issues with some of their holdings.

Vanguard – S&P Index

This is an elegant two-fund solution that covers the TOTAL stock market with the highest number of holding in our combinations. It’s also quite cheap and has very low turnover.

iShares – S&P Index

S&P index scheme is probably the best-known to the general investing public. It’s a clean three-tier option and is a decent choice despite the relatively low number of holdings. Interestingly, turnover is much lower here as the indexes membership is managed by committee and not quantitative rules. Also note that SPDR has competing offering with SPY, MDY and SLY but not a total market option.

 Mix & Match – DON’T DO IT

You wouldn’t believe how many times I have seen real-life portfolios that mix funds from different providers in an attempt to cobble together “total market” exposure. People look at the fund names and assume that large, mid and small funds are exactly that and are interchangeable. Exhibit 3 shows couple examples of this creative splicing. Clearly there are lots of gaps and overlaps!

Exhibit 3 – Examples of Creative Splicing


Source: Index provider websites, PlanByNumbers

The second example is a very common one – after all SPDR S&P 500 (SPY) and iShares Russell 2000 (IWM) are synonymous with large and small cap stocks, respectively. In fact, among all ETFs they are number one (112 million shares per day) and number three (48 million) by average trading volume (EEM is number two in case you were wondering). So let’s take a quick look at the results of combining these two instead of using Russell 1000 and Russell 2000 together (Exhibit 4). You would miss out on a number of well-known names such as Las Vegas Sands, Tesla and LinkedIn (although you might be happy to be out of TSLA today (5/8/14) as the stock is down about 10% on earnings). Moreover, the top names in S&P 500 would be overweighed relative to Russell 1000.

Exhibit 4 – Mixing SPY and IWM



1)      Know if your index uses two or three tiers so you don’t overlap categories

2)      Do not mix index providers, pick one and stick with it

3)      Pay attention to expense ratios of your fund combination, number of holdings and turnover


The Bear Ate [Some of] My [Diversified] Portfolio

In the last post we looked at annual declines in the domestic stocks (The Bear Ate My Portfolio).  Let’s see what happens when we add foreign stocks and bonds to the portfolio mix.

First off, I added a new metric to the table – Total Years.  It calculates the number of years that the investment was “dead money” or how long it took to get back to even including both the decline and the subsequent recovery.  To refresh the memory, Exhibit 1 has the numbers for domestic stocks only.

Exhibit 1 – Recent Bear Markets (S&P 500)


Exhibit 2 looks at how the numbers change if we add foreign stocks (represented by MSCI EAFE index).  To be clear – we are analyzing the portfolio mix for the years when S&P 500 alone had negative returns.  The results are fairly similar to the original.  The biggest difference is that one of the mildly negative years is eliminated (0.4% return in 1977).  This reduces that average duration numbers but actually increases that drawdowns for the last two episodes.

Exhibit 2 – Recent Bear Markets (70% S&P 500 / 30% MSCI EAFE)


Next table goes a step further and adds domestic investment-grade bonds to the portfolio (Barclays US Aggregate Bond Index).  Results for the 40% domestic stocks / 20% foreign stocks / 40% bonds are show in Exhibit 3.  Two of the periods are eliminated (1977 and 1981), while the other drawdowns become much milder and easier to recover from.

Exhibit 3 – Recent Bear Markets (40/20/40)


Key Takeaways

The analysis above is just another way of showing that adding bonds to the portfolio reduces its volatility.  This, of course, comes at the price of lower long-term returns.  Thus, investors should construct their portfolios based on the individual risk tolerance and time horizon (how long they can afford to be in “dead money” period without locking in losses).


As an aside, I wanted to take a look at how the all-domestic stock portfolio fared during the Great Depression.  As you can imagine, it was a rather difficult period for stock investors (Exhibit 4).  Starting in 1929, the initial drop through 1932 was 64.2% and required a whopping 180% return to break even.  It took another four years to do that resulting in an eight-year period of “dead money”.  Additionally, another leg down started in 1937 and didn’t recover until 1943.  So with the exception of a brief positive blip, the market stayed under water from 1929 to 1943 or full 15 years!  Of course, that was the absolutely worst investing period in the modern era and it’s not likely to be repeated any time soon.

Exhibit 4 – Great Depression Market Performance