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Market View

Investors may not realize that many growth- and value-based indexes could introduce unanticipated—and changing—style and sector exposures. 

A recent Bloomberg article highlighted an intriguing development in today’s U.S. equity market: there are now more indexes than stocks.1 Certainly, much of the proliferation of indexes has been driven by the recent surge of interest in so-called “smart beta” strategies, which often track bespoke benchmarks. However, this telling statistic underscores the growing influence of indexes in the development and tracking of investment strategies—and the importance of understanding how they are constructed and maintained.

Indeed, while equity indexes are broadly categorized as “unmanaged” (and cannot be invested in directly), there usually is a carefully formulated process informing how they are built and maintained. Index construction often adheres to a rules-based methodology for inclusion (initial membership of a particular stock or stocks) and reconstitution (addition, subtraction, or reweighting of member stocks according to index guidelines), which is transparent to all market participants. Many of the more traditional indexes are defined by two characteristics: market capitalization (the size of index constituents' market value), and style (value or growth, for example).

The size element is relatively straightforward, as the market capitalizations of all companies in the investment universe can be ranked at a point in time, and a certain segment of that list included in an index (for example, the Russell 1000® Index includes companies with market capitalization ranks 1 through 1,000).

What may be less straightforward, especially across different index providers, is the segmentation of companies by style. Many statistics can be used to measure “value” and “growth,” and there is no universal agreement among index providers as to which are most appropriate. Each statistical approach has merits championed by those who choose to employ the underlying metric, and flaws that detractors argue disqualify the metric from serving as the defining parameter. For example, analysts will argue about the best statistical ratio to measure value: is it price-to-earnings, price-to-book, price-to-sales—or even something else?

Ultimately, index providers must determine which metrics they will employ to categorize stocks as “growth” or “value.” Further muddying the waters is the fact that, in many instances, the terms are not mutually exclusive—that is, a stock may be in both the Russell 1000® Growth and Russell 1000® Value indexes at the same time!  

Why Does This Matter?
The potential for such confusion, then, is important, because the composition of indexes may end up surprising investors. For example, several of the largest positions in the Russell 1000 Growth Index have failed to demonstrate any actual sales growth (see Table 1). This is due to the way that index provider FTSE Russell measures value and growth, and how it constructs its indexes. FTSE Russell uses a stock’s book value-to-price (the inverse of price-to-book) to measure “value,” and historical and anticipated growth rates to measure “growth.” This approach can lead to the dual index-residing definition mentioned above. A low book-to-price ratio (the inverse being a high price-to-book ratio) can lead to stocks landing in the Growth index, since they do not qualify as value—that is, in some cases, growth may be defined as the absence of value.

 

Table 1. Many of the Biggest “Growth” Companies Display Slow, or No, Growth
Price-to-book value ratios and three-year growth rates (historical) for the top 25 companies, by market capitalization, in the Russell 1000® Growth Index, as of April 28, 2017

Source: FactSet.  The historical data shown are for illustrative purposes only and do not represent any specific portfolio managed by Lord Abbett or any particular investment. Indexes are unmanaged, do not reflect the deduction of fees or expenses, and are not available for direct investment.
Past performance is not a guarantee or a reliable indicator of future results.

 

This is not meant as a critique of index providers but rather to offer an example highlighting the importance of investors understanding what they own. An investor’s perception of a “growth” or a “value” company may not align with the criteria that index providers use to identify these types of companies.

How Does This Happen?
How, then, for example, might slow-growth companies end up in a growth index? To answer that, we must first understand the concept of index reconstitution. Both the size and style criteria that qualified a stock for inclusion in a certain index may change over time. To account for this, many index providers regularly update, or reconstitute, their index constituents to ensure that the group of stocks accurately reflects the index provider’s rules-based methodology. This can have a meaningful impact on the composition of various indexes.

Of course, some changes are straightforward, such as when a company’s stock “graduates” from a smaller-cap index to a larger-cap index as it grows in market value.  However, changes in style (as defined by the index provider) can be less clear. And, in many cases, several stocks in a specific industry or sector may move together. This can have a significant effect on the makeup of an index, both at the stock level and when taking a broader view of industries or sectors. What may have been “growth” in the past may no longer be “growth” in the years ahead.

As illustrated in Chart 1, this can lead to some major shifts in index composition. For example, the weighting of the energy sector in the Russell 1000 Growth Index has doubled during the annual reconstitution (which occurs in June) on two separate occasions during the past 10 years, and has been cut in half three times.

 

Chart 1. Full or Empty? Energy Sector’s Weighting in a Key Growth Index Has Varied Widely
Percentage weighing of the energy sector in the Russell 1000® Growth Index, 2007–16

Source: FactSet.
The historical data shown are for illustrative purposes only and do not represent any specific portfolio managed by Lord Abbett or any particular investment. Indexes are unmanaged, do not reflect the deduction of fees or expenses, and are not available for direct investment.
Past performance is not a guarantee or a reliable indicator of future results.

 

Needless to say, these large swings in the weighting of a particular sector can have a meaningful impact on investors’ performance expectations. Investors who thought they would gain a certain exposure to different sectors in a style-focused benchmark may be surprised to learn that a particular group now represents a markedly different percentage of the index after a reconstitution.

The Pursuit of Style Purity
When using an index as a benchmark or investing in a strategy that closely tracks index performance, it is important to understand how the index provider is selecting companies and whether the resulting group of companies aligns with the characteristics that the investor is looking for. Furthermore, indexes can change drastically with regular reconstitutions, introducing a different set of exposures and sensitivities after each update.

In short, indexes may prove useful in tracking the performance of a particular style overall, but membership in a broad benchmark is not a definitive way to identify growth or value equities on an individual basis.  Investors who desire a more refined approach to a specific style may wish to consider another option: an active manager. Such a manager can construct a portfolio of companies that meets their own definition of growth or value and can maintain that strategy on a real-time basis—without waiting for a yearly update.

 

1“There Are Now More Indexes Than Stocks,” Bloomberg, May 12, 2017.

 

MARKET VIEW PDFs


  Market View
  U.S. Market Monitor

CONTRIBUTING STRATEGIST

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