As indexing has grown in popularity, I’m often asked: What makes a great index?
It depends on the goals of the organization and the investor. For me, a great index represents the desired risk exposure (size, value/growth, or other factors) that can be effectively replicated at a low cost to the benefit of the investor. Furthermore, a great index reflects how fund managers actually invest in the marketplace. There are various ways to achieve this.
What differentiates CRSP is that we do not define small-, mid-, and large-cap indexes based on a fixed count, but rather a percentage of the entire market cap. While there are differences in returns between small-, mid-, and large-cap stocks, academic research into capitalization finds no distinct narrow statistical “break points” that define these categories.
CRSP’s research shows that an index provider’s break point decision is often a reflection of industry perception and practice. Index providers have frequently made these decisions by using counts of securities as proxies for market capitalization (e.g., a large-cap index may be defined as the largest 1,000 stocks and a small-cap index may include stocks ranked 1,001–3,000).
Because the number of publicly traded securities changes over time, CRSP’s solution is to base its indexes on cumulative market capitalization. This parallels industry convention in international markets, making global diversification on a cap-basis more accurate and easier to implement.
To sum up, the choice of the cumulative-capitalization method delivers consistent exposure to size without any sensitivity to a specific time or number of companies in the market—making CRSP indexes highly suitable for use in investment and policy portfolios and contributes to ease of use for the portfolio manager.
Another differentiator for CRSP is that we use a broader set of metrics to define value/growth, and we do not force the two style indexes to be symmetric. Therefore, our indexes accurately reflect the complexity of information processed by managers when assigning security to value or growth. Furthermore, by computing value/growth scores relative to the capitalization, investors can more accurately invest in the managers’ opportunity set.
As part of continually improving our indexes, starting with the September 2017 ranking, we instituted a five-day transition window for quarterly rebalances. This change was made to better reflect how professional money managers gradually transition between the positions in their portfolios, and augments our packeting migration process. It makes more sense—and is consistent with how professional investors behave.
I should point out that while I’m biased in favor of CRSP’s approach, the vast majority of index providers follow best-practice standards in the maintenance of their indexes, although we do disagree on matters of methodology. That said, we encourage organizations to look under the hood of index construction. Only then will they know what indexes align best with their goals.
- All investing is subject to risk, including the possible loss of the money you invest.
- The performance of an index is not an exact representation of any particular investment, as you cannot invest directly in an index.
- Vanguard funds are not sponsored, endorsed, sold, or promoted by the University of Chicago or CRSP, and neither the University of Chicago nor CRSP makes any representation regarding the advisability of investing in the funds.
- Opinions expressed by Mr. Barclay are his own and do not necessarily reflect the views of Vanguard or its management.