It’s past time to Russell up new benchmark for large-caps

Which major stock market index best represents large-capitalization U.S. stocks as an asset class? Most of the public would argue the Dow Jones Industrial Average is the quintessential market barometer of blue-chip stocks.

Since its introduction on May 26, 1896, by Charles Henry Dow, it has been the most widely quoted market barometer. It is valued mostly for its long history and its computational simplicity. As a benchmark today, however, the Dow has three major shortcomings.

First, 30 stocks is too few to capture the price movements of a market that at midyear contained 537 issues with market values exceeding $3 billion. Second, it is biased toward industrial companies with long trading histories, when many more dynamic stocks have come into their own in a few short years. Finally, high capacity, high-speed computers make the distortions inherent in a price-weighted index an unacceptable tradeoff for simplicity.

Although a $1 change in the price of any Dow stock has the same effect on the average, higher-priced stocks tend to move greater dollar amounts than lower-priced stocks, even though the percentage change might be exactly the same. There is no reasonable argument to justify the implication that a 10% gain in IBM, which closed June 30 at $129.25 a share, is more than four times as important as a 10% gain in Disney, which closed at $30.81

Most investment professionals view the Dow as being of limited importance — and that only because of its tradition and its use by the public at large. Their choice of a proxy is Standard & Poor’s 500 stock index. The S&P 500 is cap-weighted, limited to 500 stocks (400 industrials, 40 utilities, 20 transportation and 40 financial institutions) in approximately 118 industry groups and 11 economic sectors.

An S&P index committee governs the composition of the index and endeavors to maintain a flexible approach to managing it rather than a rigid set of rules. Maintaining stability of the population of companies within the S&P 500 index is of primary consideration.

In recent years, however, the S&P 500 has come to be seen as too small, incomplete, inconsistent and arbitrary to adequately represent the universe of the large-cap equities making up today’s market. A growing number of investors regard the S&P 500, like the Dow, as too narrowly focused on too few large-cap stocks, and think it must be replaced by a broader, more representative index.

Many investors now regard the Russell 1000 as a better benchmark for large-cap U.S. stocks than the S&P 500. Its rules for inclusion are straightforward and consistent. The Russell 1000 index consists of the 1,000 U.S.-domiciled stocks with the largest market caps (adjusted for cross holdings).

The index is reconstituted yearly, and its constituents exist and are available on a monthly basis back to Jan. 1, 1979. It is weighted by adjusted market capitalization. In order to include only the investible portion of each security in the index, the shares outstanding are adjusted for large private holdings and cross-ownership.

At annual reconstitution each June 30, each stock is ranked by total market capitalization, but weighed according to the portion available for investor purchase.

At yearend 1998, excluding multiple listings, closed-end investment vehicles, limited partnerships and non-classifiable companies, there were 2,898 common stocks listed on the New York Stock Exchange and 5,068 on the Nasdaq/Amex, for a combined total of 7,966 issues. These nearly 8,000 common stocks had an aggregate market capitalization of approximately $12.8 trillion.

a reasonable gauge

For the purposes of this index comparison, this aggregation is referred to as the total market proxy. Although it is not intended as a large-cap proxy, we believe it is a reasonable gauge of U.S. economic sector activity and diversification.

After reviewing the uses to which benchmarks are put, we selected 10 criteria in order to compare how well the S&P 500 and the Russell 1000 serve as an asset class proxy for today’s U.S. large-cap stocks. These criteria are:

* Breadth. The Russell 1000 is superior in terms of its number of holdings and aggregate market capitalization as of June 30, $11.6 trillion vs. $11.2 trillion.

* Consistency. The Russell 1000’s selection discipline makes its process consistent. The S&P committee’s rules and standards can and probably do vary with time, causing seemingly identical situations to be treated inconsistently.

* Objectivity. The Russell 1000 has an objective selection discipline for determining the composition of its index. The imposition of an index committee on S&P’s selection process injects a subjective bias.

* Diversification. The economic sector composition of the Russell 1000 is much closer to the total market proxy of investible U.S. securities.

* Market capitalization: range, density and age distortions. Constituents of the Russell 1000 and S&P 500 fall within a range of similar market caps, but the Russell index has twice the number and a greater total market cap, giving it greater density. In addition, the S&P index committee’s desire to constrain turnover has created a systematic age bias that contributes profound distortions in the composition of the index. The Russell 1000’s greater market cap and lack of distortions give it a strategic advantage.

* Continuity of market capitalization. The exclusion of important large companies creates gaps in the S&P 500’s universe. The Russell 1000’s market cap distribution is continuous, and therefore superior.

* Risk composition.The two indexes have equivalent aggregate betas.

* Growth and value indexes. The Russell 1000 and the S&P 500 differ in their definition of growth and value styles of investing. Neither appears to have an advantage.

* Domicile issues. The Russell 1000 contains no foreign-domiciled stocks, whereas the S&P has nine constituents that are domiciled outside of the United States. Although the weighting in foreign stocks at midyear is 2.7%, which might seem small, the severely depressed energy and cyclical issues temporarily understate the S&P 500’s historic foreign exposure.

* Performance. The Russell 1000 performance is more representative of the large-cap U.S. stocks as a whole than the S&P.

The Russell 1000 is at least equal to the S&P 500 on all 10 of the benchmark criteria, and is superior on eight of them. Its consistency, objectivity of composition and the continuous nature of its distribution are far more pleasing conceptually than the sample biases inherent in the S&P 500 index committee’s selection process.

The S&P 500 has shortcomings similar to those of the Dow: Its basket of stocks is too small, given the increasing popularity of index funds; it is biased toward industrial companies, frequently ignoring young stocks with more potential; modern computational ability makes its distortions an unacceptable tradeoff for relative simplicity.

We conclude, therefore, that the Russell 1000 is superior to the S&P 500 as an index for today’s large-cap U.S. stock market.

There is a serious fundamental flaw in gauging large-cap stocks with too narrow an index, and that relates to using index funds in a less than efficient market. Today, indexing to the S&P 500 is pervasive, appearing in mutual funds, variable annuities, internally managed corporate and public pension plans, and institutional separate accounts.

By Dec. 31, total assets indexed to the S&P 500 were estimated by PricewaterhouseCoopers LLP to have grown to $1.3 trillion, or 13.1% of the total market cap of the S&P 500. It is possible new assets are being misdirected into too narrow an index, creating a situation where too many dollars are chasing too few stocks, reducing their liquidity and raising their prices. There appears to be a growing recognition and concern that the stock market as measured by the S&P 500 has risen to price levels that are disproportionate in value to those of stocks not in the index.

The recent availability through the New York Board of Trade of futures and options based on the Russell 1000 provides arbitrage opportunities for investors who believe a more traditional parity between the prices of stocks in the S&P 500 and those not in the index will be reestablished.

If, for example, an investor believes stocks in the S&P 500 are overvalued, and those non-S&P 500 stocks in the Russell 1000 are undervalued, he could sell the S&P 500 futures and buy the Russell 1000.

The degree to which such arbitrations take place is likely to determine the pace at which the Russell 1000 overtakes the S&P 500 as the standard for measuring the performance of large-cap U.S. stocks.

Mr. Carty is the founding principal and chief investment officer of New Millennium Advisors in New York. This article first appeared in sister publication Pensions & Investments.