In these pages we typically reference the S&P 500 Index because it is a widely used and well-known index. In this and following notes, however, we are going to use the suite of Russell US Indices because of their elegant design and formulation and the resultant insights that can be brought forth from them. To develop a clear understanding of what the insights are, it is first necessary to review how these indices are constructed.

Russell’s broad US Equity Index is the Russell 3000 Index, which consists of the largest 3,000 stocks in the US.  This index represents approximately 96% of the total value of the US stock market. There are literally a couple thousand more stocks that could be included in a US index, but these smaller companies are notoriously illiquid and many fail, which makes investing in them challenging. Thus, for the ensuing analysis, the Russell 3000 is a fine representation of the US stock market.

After identifying the largest 3,000 stocks in the US stock market, the Russell 3000 index is then stratified into different sub-segments. The Rusell 1000 Index represents the largest 1,000 stocks from within the Russell 3000 Index, while the Russell 2000 Index represents the smallest 2,000 stocks from within the Russell 3000 Index. For perspective, The Russell 1000 Index represents about 93% of the total cap of the Russell 3000 Index, while the Russell 2000 Index represents 7%. The Russell 1000 Index is a large cap stock index and the Russell 2000 Index is a small cap stock index.

The Russell 3000 is also divided into style sub-indices. By identifying companies with “Growth” investment style characteristics or “Value” characteristics, we can also see whether one investment style dominates another in any discrete period. Russell accomplishes this by assigning a certain subset of the Russell 3000 Index to either a growth or value substyle, diving the entire value of the Russell 3000 index into one of the two style indices. The above methodologies for separating the cap and style traits then allows for some really cool and illuminating analysis, which is where we turn next.

Let’s begin with some long-term perspective.  Below is a chart of the returns of the above-mentioned Russell Indexes starting in 1995.

What stands out in this chart is that both Large Cap and Growth stocks have outperformed all others since 1995; AND it’s not even close! The big question is whether there is a theory that might justify why large cap growth stocks SHOULD outperform all other stocks over nearly 30 years? If there is no theory, is this an illusory pattern with no long-term theoretical basis? Over 100 years will all index returns converge?

There have been theories proffered in the past (most famously Fama and French) stating small cap stocks and value stocks should outperform based on the idea of a risk premium framework. Of course, these findings were supported by decades of data suggesting that this had been the case; that small cap and value stocks outperform all others. But since Fama and French, the opposite has happened: Large Cap and Growth has outperformed. Has something fundamentally changed? Some people say cap weighted indices and index investing is driving these distortions. So now after the last 30 years, should we then emphasize large cap growth stocks rather than small cap and value stocks? We ask the following: are all these supposed theories just an effort to explain random outcomes that look more meaningful to humans who are hard-wired to see patterns, even when there isn’t one? Should we expect new fancy research from academia suggesting a new theory supporting large cap and growth investing? We won’t be surprised if we do.

What is an investor to do in response to compelling research suggesting a new preferred method for investing? One either just buys the Russell 3000 and forgets about trying to beat the index, or one attempts to outperform the index by concocting a strategy for doing so. There are literally thousands of professionally managed strategies available that attempt to beat the market. And there are literally thousands of ways professional managers seek to outperform. Most fail. That’s the hard truth.

We at WealthPlan focus on engineering portfolios for our clients that help them meet their long-term objectives with prudent levels of risk. Our main priority is using the capital markets to achieve the specific portfolio outcome we are seeking for our clients. Certainly, if we happen to generate some excess returns for our clients as we seek a portfolio outcome for them, we’ll take it! But we don’t make excess return our primary objective. Our primary objective is to help our clients get what they want and need from their investments to successfully retire and live comfortably. In our next note, we will tackle some simple rules-based strategies one might use to beat the Russell 3000 Index to show how hard the task of beating an index is. Until next time, enjoy your summer.

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DISCLOSURES

The Russell 3000 Index is a capitalization-weighted stock market index, maintained by FTSE Russell, that seeks to be a benchmark of the entire U.S stock market. It measures the performance of the 3,000 largest publicly held companies incorporated in America as measured by total market capitalization, and represents approximately 98% of the American public equity market. The index, which was launched on January 1, 1984, is maintained by FTSE Russell, a subsidiary of the London Stock Exchange Group.

The Russell 1000 index is a United States market index that tracks the 1000 largest companies. The Russell 1000 index is an important gauge for how US Large Cap stocks are doing. This index is very closely correlated to the S&P 500 since they both cover large cap US stocks. Addtionally, the Russell 1000 has had its largest drawdowns during the Tech Bubble in 2002, and the housing crisis leading to a recession in 2009.

The Russell 2000 tracks the roughly 2000 securities that are considered to be US small cap companies. The Russell 2000 serves as an important benchmark when investors want to track their small cap performances versus other sized companies. The Russell 2000 tends to have a larger standard deviation in comparison to the S&P 500.

The Russell 3000 Value Index covers United States securities with a focus on value from a fundamental perspective. This index can be important for investors that would like to benchmark for a value or conservative portfolio. Historically, the Russell 3000 Value index tends to have smaller drawdowns during pullbacks in the market, but also lower returns when the overall market is trending higher because of the characteristics of the underlying holdings.

The Russell 3000 Growth Index covers United States securities with a focus on higher growth rates overall. This index can be important for investors that would like to benchmark for a growth or aggresive portfolio. Historically, the Russell Growth index tends to have larger drawdowns during pullbacks in the market, but also higher returns when the overall market is trending higher because of the characteristics of the underlying holdings.

Indices are unmanaged. An investor cannot invest directly in an index. They are shown for illustrative purposes only and do not represent the performance of any specific investment.

The opinions voiced in this material are for general information only and are not intended to provide specific advice or recommendations for any individual. To determine which Investment(s) may be appropriate for you, consult your financial advisor prior to investing. Information is based on sources believed to be reliable, however, their accuracy or completeness cannot be guaranteed.

No investment strategy can assure success or completely protect against loss, given the volatility of all securities markets. Statements of forecast and trends are for informational purposes and are not guaranteed to occur in the future. All performance referenced is historical and is no guarantee of future results. Securities investing involves risk, including loss of principal. An investor cannot invest directly in an index.

The information in this communication applies solely to the intended audience and in no way amends, revokes, or otherwise alters the existing agreements and relationships between WPIM and its clients.  This communication is not a binding offer, expressed or implied.  WPIM undertakes no obligation to update or revise the information herein or in any referenced third-party resource due to new information, future events or circumstances, or otherwise.

WealthPlan Investment Management (“WPIM”) uses data compiled and/or prepared by third parties (“Third Party Data”) in the delivery of Licensed Research and Data. Third Party Data is not owned by WPIM and user may be required to obtain permission directly from third parties for further use of Third-Party Data and may be required to pay a fee depending on the use contemplated by the user.