Sake and CRSP

The question came from a good friend in the asset management business over a cup of sake. Talking about a presentation to his firm from Blackrock, one of the biggest ETF/Mutual fund companies in the world, he had been surprised by a trivia-like data point, “What is the percentage overlap of ETFs in the small cap space between Blackrock and Vanguard?” I guessed 80%. The correct answer was less than 10%. What?

Adding to our ongoing conversation about the importance of ETFs in the portfolios of the individual investors who enjoy reading Invest-Notes, this new data point is worth discussing. BlackRock offers the iShares Russell 2000, IWM. For no particular reason I assumed that the Russell 2000 index was the defacto choice for the biggest ETFs since it also tends to be a commonly used benchmark for performance. Vanguard uses CRSP for its small cap fund, VBR. I’d never heard of CRSP.

In last week’s Economist, there was an interesting article on the growing clout of companies that provide the indexes used to create exchange-traded funds. The article did not mention CRSP, even though there is now about $225Billion worth of indexed funds using CRSP as performance benchmarks. Who are those guys?

https://www.economist.com/news/finance-and-economics/21727090-their-role-facing-greater-scrutiny-result-financial-market-index-makers-are

The Center for Research in Security Prices (CRSP), originated at the Booth Business School at the University of Chicago. So as we’ve talked about things like market capitalization (VOO versus RBC) being a driver in ETF composition worth thinking about, it might just be that the index used for portfolio composition is even more important. Who knew there were so many?

Tools like Morningstar allow for a quick look at the key components of ETFs, with the idea that an investor can make a quick – and easy? – decision on where to put their money by contrasting their differences. In reality, it becomes much more complicated when competing indexes determine the portfolios of ETFs claiming to track the same market sectors. An example of how this is supposed to work, is here:

http://www.invest-notes.com/2017/06/18/cigarettes-and-soda-pop/

For starters, there are also small cap funds from iShares, Charles Schwab, WisdomTree, DFA, and others. While some characteristics are easy to understand such as a tilt toward value or growth stocks, more difficult to quantify are factors such as how the portfolios are regularly rebalanced. Important because there are many thinly traded stocks in this space. Or, in this case, the criteria for the composition of the fund’s holdings.

In the case of CRSP, to be included in its small cap index a stock must be smaller than 85% of all other U.S. stocks, but bigger than the smallest 2%. Vanguard’s offering, VBR, consists of around 800 stocks with the top ten holdings only accounting for 5% of the total value of the portfolio. By contrast, iShares IWM holds, well, the 2,000 individual stocks that make up the Russell 2000, where less than 3% of the fund’s holdings are in the top ten. This makes a side-by-side comparison of the top 50 holdings in each fund mostly useless. Other than seeing clearly the lack of overlap in the two funds, each list consists of names that will be unfamiliar to most equity enthusiasts.

Ultimately, the safest course to pursue in such muddy water is to focus on fees. VBR has an expense fee of just .08%, handily beating the expense ratios of most other small cap ETFs where fees range from .20% to over .5%. And the performance has been pretty solid as well. I have about 5% of my personal IRA in VBR.

Finally, it should be noted that this has not been a stellar year for small capitalization stocks, their biggest siblings putting in a much better performance recently. Which might lead a savvy investor to consider adding some ETF exposure to the small cap space while prices are not as expensive as other sectors of the market.

And for any fans of Miles Davis out there, check out a new Jazz-Notes.

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