All Size Indexes Are Not Created Equal

One of the classic exposure questions in equity investing regards market capitalization size, i.e., whether one should choose large caps, mid caps or small caps. The capitalization size segment decision is an important one, as it sets up the potential for very different performance characteristics over time.

The Devil Is in the Details

How should one approach the decision of which small-cap or mid-cap index is best as a benchmark? If they all focus on U.S. equities, wouldn’t they all be quite similar?

The fact is that there is no universally accepted truth as to what market capitalization boundaries constitute mid-cap stocks or small-cap stocks. As a general descriptor of market capitalization buckets, we tend to think these buckets are useful to describe market capitalization exposure in various indexes:

Small Caps: Less than $2 billion

Mid Caps: Between $2 billion and $10 billion

Large Caps: Greater than $10 billion

A Quick Size Spectrum Analysis after a Strong Year

U.S. equity markets—large caps, mid caps and small caps alike—performed well during 2013. Following that performance, it is interesting to evaluate the size characteristics of traditional market capitalization-weighted indexes using the range of market caps described above. In this piece we take a look at WisdomTree’s U.S. earnings family of Indexes, specifically the WisdomTree Earnings Index (WTEI), WisdomTree Earnings 500 Index (WTEPS), WisdomTree MidCap Earnings Index (WTMEI) and WisdomTree SmallCap Earnings Index (WTSEI).

Figure 1a: Surprising Size Dispersion in Small-Cap Indexes

Figure 1b: Surprising Size Dispersion in Mid-Cap Indexes

Ultimately, the point of this size analysis is to help people understand that index construction and methodology can have the potential to lead to very different sets of index constituents. We find it surprising that Indexes geared toward the same market capitalization size segments can exhibit such significant differences in the sizes of constituents that they include.

CRSP U.S. Small Cap Index Stands Out: This is a very inclusive small-cap index. However, since it is market-capitalization weighted, some of its biggest weights—ultimately adding up to more than 70%—are in stocks with market capitalizations above $2 billion. This leads to a drifting upward along the market capitalization spectrum, with a weighted average market cap of $3.2 billion as of December 31, 2013. For reference, the Russell 2000 and S&P SmallCap 600 indexes are at approximately $1.8 billion, and WTSEI is at slightly over $1 billion by this same metric at this time.

WTSEI and WTMEI Clearly Different: Something is clearly going on with these two options, in that WTSEI had 0% of its weight in firms above $2 billion and WTMEI had 0.6% of its weight in firms above $10 billion in market capitalization. But before people start jumping to conclusions, it should be noted that neither has absolute market cap boundaries included in its selection process.