Index inclusion: chasing profits can lower returns

By Catherine Yoshimoto, director, benchmark development

If we look at the largest US companies by market capitalization, we can see that many of them don’t have extensive histories of profitability. In fact, some of them only became consistently profitable less than a decade ago—or in a few cases, even less than a year ago.

This trend of newer companies leapfrogging older ones has to some degree become the new normal. It even has some questioning whether the future of asset management should look more like venture capitalism, where the focus is on a company’s future earning potential—not backward-looking profitability analysis.

The trend also raises questions when it comes to index design. Russell Indexes—like all indexes—are a product of their inclusion methodology. And because our Russell Index methodology doesn’t require companies to meet profitability criteria for inclusion, many companies have been added to our indexes just as they’re beginning to grow—making a material difference in index performance.

Tech and innovation rise to the top

The largest US companies by market capitalization are no longer the older, stalwart large cap companies that have been household names for generations, but rather more modern ones widely known for new technology and innovation. As shown below, five of the top 10 largest Russell 3000 constituents are Technology companies, and two are Consumer Discretionary whose business models are built on technology and innovation.

Source: FTSE Russell. Data as of January 31, 2021. Past performance is no guarantee to future results. Please see the end for important disclosures.

The shift is also evident if we look at the largest companies in the Russell 3000 Index just 15 years ago. As shown below, only one Technology company comprised the top 10 holdings in December 2005, with the majority coming from less cyclical, more defensive sectors such as Energy, Health Care, and Consumer Staples.

Source: FTSE Russell. Data as of December 31, 2005. Past performance is no guarantee to future results. Please see the end for important disclosures.

This trend demonstrates that a long-term record of financial stability is no longer required to rise to the ranks of the largest US equities. Investors appear to have shifted to more of a forward-looking approach, perhaps with the belief that technology and innovation have the potential to drive company growth.

The cost of waiting for profitability

We use a rigorous and transparent methodology to construct our Russell Indexes, where companies are required to meet a robust set of criteria for inclusion. And while these criteria are designed to screen companies for eligibility based on characteristics such as minimum voting rights, investability, and liquidity, they don’t include profitability requirements.

If our index methodology did require four consecutive quarters of profitability for inclusion, there are several instances where companies wouldn’t have been included in the index until many years later. As shown below, we added some companies to the Russell 3000 Index shortly after their IPOs—and these companies subsequently took the better part of a decade to become profitable for four consecutive quarters.

Source: FTSE Russell. Data as of December 31, 2005,  Past performance is no guarantee to future results. Please see the end for important disclosures. *Russell 3000 additions are to the Russell 1000 (R1) unless a date is noted for the Russell 2000 (R2). The inception date of the Russell 3000 index is January 1, 1984.

A process which prescribed four consecutive quarters of profitability, would have  impacted  Russell Index performance. As shown below, all of these names grew significantly in the intervening period between inclusion in the Russell indexes and profitability..

Some names would still be waiting for eligibility

In the absence of profitability requirements for index inclusion, we’ve added several Technology companies to the index whose market caps have grown to reach over $100 billion—but who still have yet to report four consecutive profitable quarters. And while the future growth of these companies remains to be seen, they’ve thus far reported positive returns since their addition to Russell indexes.


What it means to be an index

An index is only useful to the extent that it accurately reflects the market it’s designed to represent. As recently as 15 years ago, it was uncommon for Technology companies with relatively short histories to be counted among the largest US stocks. But the investment landscape has evolved such that a company’s journey from IPO to mega cap can outpace its path to profitability. And if profitability requirements mean these companies are overlooked when it comes to equity index inclusion, then the index becomes a less accurate reflection of the market—and the potential impact on performance can be meaningful.

Originally published by FTSE Russell, 3/15/21

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