How Popular Market Indexes Are Constructed with Athanasios Psarofagis

[00:00:00] Welcome to excess returns where we focus on what works over the long term in the markets.

[00:00:05] Join us as we talk about the strategies and tactics that can help you become a better

[00:00:09] long-term investor. Justin Carboneau and Jack Forehand are principals at Validia Capital

[00:00:13] Management. The opinions expressed in this podcast do not necessarily reflect the opinions of

[00:00:17] Validia Capital. No information on this podcast should be construed as investment advice.

[00:00:21] Securities discussed in the podcast may be holdings of clients of Validia Capital.

[00:00:24] Hey guys, this is Justin. In this episode of excess returns, Jack and I talk't know, just recently there's been some stuff in the Wall Street Journal. I think Bloomberg has put out some stuff. It's been a combination of articles talking about different indexes and different exposures that they have as a result of different methodologies that they have, which is what we're going to tackle today. And also this, I've seen recently nailed it. There's 3000 plus ETFs in the US now, right? A lot of it's active, fine. We could talk about that later, but most of it's indexed. And a lot of people just pick an ETF based on a name, but you really have to get into the index differences, right? Every index house is different the way they even have definitions of different factors or market caps or whatnot. So it's really important

[00:03:03] to understand that. I get it. It's not good point. And you're right that it's blurry. So we have this category, we started call like new active work. It's not really active. But it might so most people when they look at passive, let's say, Oh, tracks and index, that's fine. Let's say like the index only has 50 stocks and it rebalances every month. And it based on this screen, like, yeah, that's a lot

[00:04:22] of rules, right? And somebody had to come up with very concentrated. Like no one's building an index as a benchmark anymore. Like that's not what the index providers are doing. They're building something that could be packaged into a product, probably sort of alpha seeking or whatnot. And that's just where most of the work is being done. So again, this is why it's so good we're doing this podcast because most of the stuff that's coming out is not

[00:05:45] quote unquote benchmark type stuff. It's interesting that your point that a third of the ETFs out there are still pretty young. Maybe they haven't even really seen a bear market. Well, maybe if they've been around three years, maybe they've seen COVID or maybe not. But can you just sort of set the stage before we get into some of the nitty gritty details as to some of the growth numbers in

[00:07:00] passive investing and ETFs? And what does it look like when you're looking at ETFs versus unusual passive trend is probably the strongest of like any region globally. It's about 50-50. And so, why it's becoming so interesting now, especially over the last like two years, a lot of asset managers are finding ways to come into the ETF market. So there's a big thing that's been there's been conversions, right? So DFA was probably the biggest one to do this, they converted

[00:08:22] about 30 billion or so mutual funds into ETFs as ETFs keep growing, it's forcing all these other asset managers to either lower their cost or move into the ETF market. And that's really the biggest trend of all, which is cost. And you can access all these strategies that we're talking about that. You can access them for pretty cheap in the ETF rep work.

[00:09:42] I think you can build a low cost global portfolio for something like two and a half basis points, was Tesla, right? So I remember like Tesla had run up, it was unlike all these other passive indexes, but it wasn't in the S&P 500 when it was the biggest one of the top 500 companies. So the unique thing that S&P does, it has this profitability screen. So it won't let companies in that don't have a year of profits. And Tesla didn't. And finally, when they turned profitable, they got

[00:11:02] added into the index. So that was probably the mentioned the profitability criteria. Do you know like how much of it is quantitative? Like they have rules and how much of it is the committee just decides what they want to do? Yeah, I mean, the rule is pretty straightforward. It just has to have four trailing quarters of profitability. And so, and that's the thing is that's how they apply to all their indexes.

[00:12:22] So it just has to have four straight quarters of profitability.

[00:12:25] Now let's say if it starts to fall outanced? Yeah, it's kind of whenever. And this one makes it even tricky whenever they decide. You know, for the most part, most will have a date, right? June or September, we're going to reconstitute the index and add the names. The S&P is just whenever. You know, I think they tend to keep it in the same, you know, on the calendar quarters,

[00:13:43] but it really, you don't know when it's going to decide right? That is coming in at such a big weight into the index. So it was a pretty unique case for sure. Before we shift to another index, I just wanted to ask you, you know, one of the things you're hearing right now is that the top companies represent a massive portion of the S&P 500 right now. And, you know, we have people talking about that like being unprecedented levels.

[00:15:00] And I'm wondering if you just have any context around that,

[00:15:02] like how much of a percentage they are

[00:15:04] of the S&P 500 right now versus what they've been

[00:15:06] at other points in history. It doesn't happen in a perfectly market cap world that would just keep running. But for sure, the other thing, when it comes in a lot of the tech ETFs or whatnot, you have to keep in mind the concentration. According to the index rules, anything can't be more than 25% or whatnot. But that's still a lot. If you have two companies that are 25% or 20%, that's half of your index in one stock.

[00:16:22] But I would say for something as broad as the S&P and the amount of assets that track now. No, yeah, that's a great point. I think that's why probably Active also under performs a lot of times, right? Especially something like this, to your point, they can't buy anymore. Like, Apple will just keep running up until it hits the upper limit, but an Active Manager is probably not going to go 25% on Apple, even though an ETF technically could. And so, yeah, that's a really great point that a lot of these funds can. But I think it just seems like gravitating towards large cap equities, US equities has worked over time and it's pretty sure that even the Dow or the Qs or whatnot have all seemed to perform really well regardless of their leading methodology.

[00:19:03] Do you know, is the Dow committee as well in terms of how they're figuring out the stocks?

[00:20:20] Good point. I think it is because it's now under S&P companies on the NASDAQ X financials. This was actually a pretty good trade like a couple of years ago. Remember when there was the SVP banking issue? So the NASDAQ was actually perfect because it was overweight tech and it had no financial exposure. It was like the perfect trade for that year. And the thing I mentioned earlier, like, yeah, it is very tech heavy.

[00:20:24] You have more tech than even some of the better benchmarked than the S&P, but it's been something that's worked for a long time. But that one construction, again, just any top 100 companies listed up in NASDAQ. Yeah. And it's interesting. One of the misconceptions I think about that with investors is people think it's 100% tech. When you talk to individual investors, they'll be like, oh, that's a technology

[00:21:42] index. And I think it is, I don't know the exact weight. I'm sure it's incredibly heavily

[00:21:45] weighted towards tech, but it's not all tech. So the Russell 2000 is pretty much like it just every issuer has a different threshold for caps, right? So the just based on the Russell methodologies, they're just gonna take the bottom 2000 companies and they're and they're tearing mark cap Threshold the S&P is But just keep in mind, if you are buying the S&P, they're both really big, and they both have a lot of assets tracking them, you're going to get a little bit more of a quality tilt in the S&P 600 small cap index. Yeah, to your point, fundamental guys like us love the small cap 600 because of the

[00:24:21] profitability screen, but that can also be a double edged sword. You get one of these

[00:24:24] markets where the growth companies are really running where we're going to spend a good portion of the discussion, that's something a lot of us in the sort of the fundamental space debate, how these different providers handle value and how they handle growth and how they separate them. And I think there's two major ones, S&P and Russell, who are doing it. And I think they

[00:25:40] have different ways they go about it. So could's a lot of underpinnings for it. That's an interesting thing that I think people get wrong both about the academic research and the index is they think about value and growth. And they think, well,

[00:27:02] I've got a value criteria, and then I've got a growth criteria. But what it really is, is cheap

[00:27:05] versus expensive for the most part. For. So I think we see sometimes investors moving towards a more composite approach, it's just to sort of flatten that out a little bit and not maybe have to deal with some of the factor timings. And in thinking about sort of the blurry line between value and growth,

[00:28:23] I think a good thing to look at is sort don't know if meta is in there, but this seems like it might be a good candidate for it. But yeah, I think the lines of value and growth can get kind of blurry. If you look at the Russell 1000, there's quite a bit of overlap, right? Like the way they do their basic ones is, okay, you have to be in one, but there's a lot that can actually

[00:29:41] be, they can be in both, right? So you have like a third of it that has a lot of overlap

[00:29:45] between the two. So again, it're only gonna pick the value of stocks, we're gonna pick the growth stocks. So it's sort of like, I guess we like to think of it as like a watered down level. So it's like, okay, at the top, let's say the Russell 1000 value is like only a little watered down. Like you get a sprinkle value, but some of these stocks can be in both. As you get further down the pure value or whatnot, it gets much more concentrated, right? There's fewer names.

[00:31:00] These ones are much stricter with the criteria.

[00:31:02] They're probably gonna give you much better exposure,

[00:31:05] like to the value factor,

[00:31:06] and you can go tools that you do. What would be the way that you would step into understanding that?

[00:32:24] Where would you go?

[00:32:25] What would you look at?

[00:32:26] What documents would you try to read? allocations that I'm getting. But the way I always like to think about things is like, okay, if I'm an investor, I probably already have the S&P 500. I'm just making an assumption here, I already have the S&P. So if I'm looking at another strategy, how does it complement that already? So what I mean is I like to look at something called active share or overlap with something like the S&P. So if I have the S&P and I have all these stocks in it

[00:33:42] and I'm buying another ETF that I'm looking at, a watered down, I would probably go towards a lot of holdings, less volatile, more overlap with the S&P and then all the way down. So I think that's it. I think just looking in the context of the portfolio is really interesting too. Cause we can always look at stuff in isolation, but it's like, okay, how does that, am I just paying more than something that just looks like the S&P 500 that I'm

[00:35:01] already getting, right?

[00:35:01] So how unique is it?

[00:35:03] Um, and then a lot of the issuer websites do like, oh, if rates are much higher, like this one might have more of an adverse impact if rates go up or whatnot. So I think it's important to look at it both in the market context and also in your portfolio context. That's very helpful. Thank you, because I think some of our audience will want to spend the time to actually do that and dig in deep.

[00:36:21] Many investors don't, or investors that use global firms, but the MSCI index seemed to be some of the more popular ones that you hear about. So I just wanted to ask, can you just talk to how those are constructed both in the developed and the emerging markets?

[00:37:40] Yeah, sure. And I agree. MSCI index, and it's not in the FTSE one. But Korea is a 12% weight. That's not negligible. That's a pretty decent weight. And that difference actually causes a pretty big performance divergence.

[00:39:01] So the thing to keep in mind when you're looking at either developed or emerging is the company,

[00:39:05] the countries that are being upgraded or downgraded, like, well, I'm already getting a lot of China exposure. Do I want to go with the index has less China or more of this and that? So again, I think it just goes back to what I was saying, like how things need to fit into like the portfolio context. But by far the biggest difference is like country classifications between the two different houses.

[00:40:20] Yeah, I think those are both very good points.

[00:40:22] And we've asked this international question

[00:40:24] to a lot of people that have come on the podcast

[00:40:27] about what is their take on international investing We always get pulled into like, okay, this is finally, and I think ethos beating the SMP by like the most ever, like on a rolling basis this year. And that kind of rolled over really quickly. So I don't know when international will come back. A lot of places seem cheap there, but, um, you know, you had said in the beginning, like on a relative basis, like us has just been the better spot to be.

[00:41:41] And, you know, maybe again, you're getting that global exposure anyway.

[00:41:44] So, um, and so maybe just flowing back to the SMP, but we'll see.

[00:42:43] So the biggest one is, you know, disclaimer, I work there about like the Bloomberg Barclays aggregate, um, which is the way it works with these

[00:42:49] traditional fixed income ones.

[00:42:51] It's market-valuated, right?

[00:42:52] So it's actually like the most debt gets the biggest weight, which

[00:42:55] seems a little counterintuitive.

[00:42:56] But that's just a lot of times just a liquidity issue.

[00:42:58] Like they, they want the largest issuers to be at the top.

[00:43:01] But the aggregates like kind of virtue traditional, like would it be like the

[00:43:04] SP 500 of bonds, it's a lot of Treacherys, MBS agencies in there.

[00:44:03] active bond managers, a lot of times the way they're beating the ag is they're just adding high yield on and off.

[00:44:05] And so if you sort of run the stats against the universal, those outperformance rates

[00:44:10] drop quite a bit when you're looking at an active manager and how they're...

[00:44:13] So that was sort of the distinct.

[00:44:14] So it's almost like saying you have the S&P, but you don't have a sector in it.

[00:44:17] It's like, well, let's just get a more comprehensive look into it.

[00:44:19] So that one's getting pretty popular.

[00:44:22] And then the other ones are very specific, like the treasury indices, like TLT has been

[00:44:27] a real big from this index discussion, which has been great, and I knew it would be, but I wanted to ask you, so last year, 2022, we obviously saw, I mean,

[00:45:42] the 60-40, it was like the worst, you think that's going to, and what's out there now and how that might influence sort of where we go with some of these more unique esoteric ETFs that aren't your traditional stock and bond portfolios. Yeah, sure. I think you're talking about the DBMF, which is a managed futures ETF.

[00:47:00] Yeah, it was one of the fastest growers last year.

[00:47:04] And so yeah, alternatives did really popular. Again, it's maybe pretty conducive to what the market has been doing. Yeah, I wanna be in the market, but I don't wanna be fully in it. I'm okay giving up some upside as long as I don't lose more than 10 or 15%. And yeah, that's definitely the, and it goes back to something we were saying, most of the products that are coming out are very, very concentrated.

[00:48:21] They're very, very unique now.

[00:48:22] It's not just, no one's launching

[00:48:24] another US large cap fund.

[00:48:26] It's just not happy.

[00:48:27] It's just not, you know, I think it's a little bit more boring when you talk about it compared to equities, like, oh, let's talk about like duration time spread in bonds. I think it can get dull very quickly, but I think it's a really interesting spot that hasn't been covered enough. So I'd be looking out for that as well as terms of like future product innovation

[00:49:44] to come more in the fixed income side. I wonder that opens up some pretty unique opportunities for some of the smaller issuers. And I think they just have to realize that you can't be competing with Vanguard. You have to be complementing Vanguard. And that's where we're sort of seeing the product launches go. If you want to go head to head with them on a generic sort of plain vanilla fun, good luck, because that's going to be a really tough sell. But if you

[00:51:01] can find something that can complement that, that's where we're thinking more of the issuers

[00:51:04] of having a little bit more success. You have to learn how to live in this post-Vanguard is if you could teach one lesson to the average investor, what would that be and why? Yeah, so I would say, and that does sound too cliche, obviously know what you're buying, right? You know, do your homework, look through the different methodologies, depending on how

[00:52:21] bogged down you want to get.

[00:52:22] The other thing is too, it's already been sure that people are doing. Good stuff, Antonato. So we really appreciate you taking the time with us and our audience today. If people want to learn more about you, I know you're on Twitter. I think you might even produce some original commentary out there. Where can

[00:53:42] they go to learn more? Yeah, Twitter is probably the best way. Just like at Sarah Fagus is my last