What’s In a Name: Do Index Funds Hold the Right Stuff? by Steve Abramowitz

Of the four advantages of index fund investing—cheapness, flexibility, tax efficiency and transparency–I had long thought the last to be the most straightforward to implement. Just define your criteria, find stocks that qualify for inclusion and remain fixed forever.

But two weeks ago I found myself frustrated trying to reallocate my portfolio by size and position along the growth-value continuum using the ubiquitous Morningstar Style Box. Did the creators of our beloved indices not succeed in validly classifying stocks into their correct category? I soon became suspicious that all was not kosher in index-land.

Many of you have probably diagnosed me as a Vanguard-phobe. But that’s only true to the extent of my envy of all you buy-and-holders who have far eclipsed the performance produced by my market antics. In the interest of fairness and reputation reclamation, I vowed that this time I would poke around Fidelity’s website to try and make transparency transparent.

Readers of my last post may remember how we learned that neither Vanguard’s S&P 500 Index Fund nor the Total Market Index Fund is truly diversified. The S&P surrogate has no small stocks and its broader sibling contains only 8%. Not surprisingly, Fidelity’s two identical offerings follow suit.

The mutual fund behemoth went one step further out of bounds, classifying none of the stocks in its International Index Fund and fee-free ZERO International Index Fund as small. In like fashion, only 4% of stocks in Fidelity’s Total Market International Index Fund are regarded as small cap.

It turns out that stocks assorted according to size are for the most part categorized correctly. The large cap proxies are the S&P vehicle and Zero Large Cap Index Fund. Approximately 80% of each is placed in the large cap space, which passes for reasonable. The parallel figure for the midcap fund is 73%, which seems borderline, but honors go to the small cap fund, which accurately placed 95% of its constituents. To see whether this small cap phenomenon might apply universally, I took a look at the corresponding fund at Vanguard, but to no avail. A modest 70% of the holdings of Vanguard’s Small-Cap Index Fund are appropriately categorized. Perhaps that 95% figure at Fidelity is just a chance outlier.

The verdict for classification by position on the growth-value dimension is far less reassuring. Only 34% of the stocks in Fidelity’s Mid Cap Index Fund and 49% of them in the Small Cap Index Fund are correctly identified. For large caps, the corresponding number is 42%.

Let’s look at the boxes formed by the intersection of the size and style ranges. Fifty-eight percent of large cap growth companies are housed in the appropriate box, but only one-fourth of their large value counterparts are so captured. The comparative figures for midcap growth and midcap value are 43% and 25%, respectively. About half of each category of small cap stocks is a good fit. I do not have an explanation for why stocks in the growth funds tend to be more correctly placed than their value contemporaries.

Let’s take a new tack. What if Morningstar is the culprit here and not the index developers?

After all, the criteria for inclusion used by the advisory service are more often than not different from those applied by the creators of the index. Who is to say which standards are most valid?

What’s in a fund’s name? How well does it characterize what’s actually in it? I was taught that index funds are more pure than active ones because there is no chance for portfolio managers to stray from their designated mission. But just how passive are index funds? Who decides whether book value should be the primary screen for selecting value stocks in a proprietary index? The answers to these questions should be made as transparent as the stocks comprising our favorite index funds.