When index funds mix but don’t match

“These problems are often invisible until market volatility occurs,” said Andrey Kotlyarenko, a senior investment product manager in Vanguard’s Investment Management Group. “When turbulence hits, investors start to see that their portfolios are riskier than the market or than they intended.”

The source of this risk stems from the different criteria that providers like Standard and Poor’s, Russell, and CRSP use to classify stocks—it’s as if some providers measure in feet and others in meters. For example, S&P, Russell, and CRSP categorize the style of 46% of large-cap stocks differently.  

S&P, Russell, and CRSP all use book-to-price ratios to assess a company’s value factor. However, their models meaningfully diverge from there. CRSP’s model uses 10 total factors, S&P uses six, and Russell uses three. In addition, CRSP identifies each security as either growth or value, but the other two providers can label a subset of companies as belonging to both styles.

The upshot: The proportion of growth and value stocks differs substantially depending on the index provider. This inconsistency can lead to significant deviations in portfolio performance and increased volatility. 

Similarly, methodology differences lead to a range of results based on market capitalization. CRSP slices its indexes into large-, mid-, and small-cap categories by targeting specific percentages of market capitalization. For example, CRSP defines large-caps as the top 85% of the total market value. In contrast, S&P and Russell use static stock counts (the largest 1,000 stocks, for example) to classify stocks based on size. As a result, the Russell 1000 covers 94% of total market capitalization and the S&P 500 covers 87.5%.¹

These differences have ripple effects. For static stock count indexes, the market capitalization percentage can fluctuate over time. Furthermore, S&P’s method has a few distinctive traits. It uses a quality tilt, excluding companies that don’t show a profit for four consecutive quarters. It also relies on a committee at S&P that has the final say on whether a company merits inclusion, which is a more subjective criterion than those used by other providers.

As a result of these variations, market cap categories differ significantly among providers.

Investors and advisors often have good reasons for using index funds as portfolio building blocks. This approach can provide flexibility to enhance existing portfolios or create intentional tilts toward growth or value, among other strategies. However, mixing index providers can increase risk factors exposure, tracking error, and volatility, potentially leading to poorer performance. 

Understanding the nuances of index construction methodologies and how well funds align with each other can help reduce unintended active risk. The fund name or classification is only the start of the story. A small-cap fund following one index provider may include a surprising number of companies that a different provider considers large-cap.

Assessing the tradeoffs in using funds from multiple index families instead of just one can help investors maximize market rewards. Conducting this research before investing may prevent the tax headaches that can result from restructuring existing portfolios. One option is to stick with a single index provider, said William A. Coleman, head of Vanguard’s U.S. ETF Capital Markets team.

“Index ETFs can serve as high-quality, flexible building blocks for portfolios,” Coleman said. “Carefully selecting them with attention to whether the indexes complement each other and help achieve financial goals is essential to giving investors the best chance for investment success.”