Why the broad market indices are essential for equity investors
Broad market indices
The below graph reflects the dramatic recovery in U.S. equity prices since the 2008 crisis. The outperformance of the broadest of the three major broad equity market industries below—the Russell 2000, with 2,000 constituent equity components—has outperformed the S&P 500 (500 constituent equity components) and the Dow Jones Industrials (only 30 constituent equity components). This series takes a look at investment options available to investors in the areas of both major equity index ETFs and traditional and non-traditional fixed income ETFs. Investment choices in the area of equities include market breadth exposure and value versus growth exposure. In the area of fixed income ETFs, we’ll look at the trade-offs between high credit quality and low credit quality, as well as short duration exposure versus long duration exposure. For a detailed analysis of the U.S. macroeconomic environment supporting this series, please see Must-know 2014 US macro outlook: The crack in the debt ceiling.
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Why the Russell 2000 outperforms narrower indices
“Market breadth” refers to the diversity of equity holdings. In the above graph, the Russell 2000 clearly has the greatest breadth, followed by the S&P 500, then the mere 30 component index of the Dow.
More price volatility in small companies
The broadest market index, the Russell 2000, outperforms other indices. This is because the Russell 2000 holds many smaller companies in its index relative to the S&P 500—and certainly relative to the Dow, which holds entirely the biggest companies from various industry sectors in its index. These smaller companies tend to have more risk, and they exhibit greater price volatility as a result.
As we see above, the inclusion of exposure to smaller companies in your investment exposure can enhance the return of the portfolio. On the other hand, during bad economic times, smaller companies can underperform larger global blue chip companies. The stock price of smaller companies tends to exhibit greater sensitivity to business cycles, as their profit margins may shrink or rise more dramatically than the margins of larger companies.
Higher cost of capital: Fewer advantageous financing opportunities for smaller companies
Similarly, smaller companies may face more expensive financing alternatives in the form of debt (bonds, bank loans) and equity issuance. In other words, these companies have a higher “cost of capital” relative to larger companies, as smaller companies typically involve a higher level of investment risk. This means smaller companies tend to outperform larger companies during a period of anticipated economic growth, though they underperform larger companies in a period of economic decline.
To see how value versus growth ETFs compare with broader indices ETFs, please read the next article in this series.
To see how various fixed income ETFs compare to one another in the current macroeconomic environment, please see Key strategy: Will deflation contain the bear market in bonds?
Equity Outlook: Cautious
Should the debt ceiling debate re-emerge after the mid-term elections in November, and macroeconomic data fail to rebound in sync with record corporate profits, investors may wish to consider limiting excessive exposure to the US domestic economy, as reflected more completely in the iShares Russell 2000 Index, IWM. Alternatively, investors may wish to consider shifting equity exposure to more defensive consumer staples-related shares, as reflected in the iShares Russell 1000 Value Index, IWD.
Additionally, even the global blue chip shares in the S&P 500 or Dow Jones could come under pressure in a rising interest rate environment accompanied by slowing consumption, investment, and economic growth. As such, investors may exercise greater caution when investing in the State Street Global Advisors S&P 500 SPDR, SPY, or the State Street Global Advisors Dow Jones SPDR, DIA, ETF’s. Until there is greater progress on the budget and federal debt issue, and consumption, investment and GDP start to show greater signs of self-sustained growth, investors may wish to exercise caution, and consider value and defensive sectors for investment, or individual companies such as Wal-Mart Stores, WMT).
Without a sustained improvement in economic growth data, there is little doubt that the debt level issue and tax reform will be a big issue later in the year. Current economic data noted in this Series suggests that the probability of the 2013 sequester issue returning—in one form or another—could be higher than many think. The data is simply not that robust—yet.
Equity Outlook: Constructive
However, if investors are confident in the ability of the USA to sustain the current economic recovery as a result of the improving macroeconomic data noted in this Series, they may be willing to take a longer-term view and invest in US equities at their current prices. With the S&P 500 Price/Earnings ratio standing at 19.65, versus the historical average of around 15.50, the S&P is slightly rich in price, though earnings have been solid. However, with so much wealth sitting in risk-free and short-term financial assets, it is possible to imagine that a large reallocation of capital that is “on strike”, to include corporate profits, into long-term fixed investments could lead to greater economic growth rates in the future, and support both higher equity and housing prices in the future as well. In the case of a constructive outlook, investors should consider investing in growth through the iShares Russell 1000 Growth Index (IWF), or through individual growth oriented companies such as Google (GOOG).