Why are Index Returns so Variable

There’s considerable variability year to year between global stock and bond asset class returns as we should expect. This is exactly what we see in Figure 1. While we often hear claims of which asset classes should be “in favor” or which may soon meet their demise, the data highlights both the difficulty in predicting short-term winners and how quickly the picture can change. Take 2022 as an example. Cash — the lowest returning asset class over the last 15 years — was the top-performing asset class over the year, besting U.S. large-cap growth stocks by more than 30%. U.S. large growth stocks were the worst-performing asset class over the year after topping the charts in two of the prior three years. With the benefit of hindsight, it’s easy to say that cash did well relative to stocks and bonds over a period of rising interest rates and heightened uncertainty. But on the first day of 2022, did you think this would be the result? Even if this had been your view, to achieve returns like those in Figure 1 would have required the conviction to buy and hold this investment throughout the entire year — no easy task.

The upside for those who invest over the long term in broadly diversified portfolios that spread investments among global asset classes is that total portfolio returns become less reliant on any single component, thereby reducing “idiosyncratic” (i.e., diversifiable) risk. By holding a classic mix of 60% global equities and real estate and 40% global bonds, for example, you can have confidence that your portfolio will neither have the highest nor the lowest return compared to the market’s components. That’s the beauty of diversification, which we believe should be a foundational principle of building sound asset allocations.¹

What You Might Not Know About Asset Class Returns

Data over the 15-year period from 1/1/2008-12/31/2022. Source: Morningstar. Return periods greater than one year are annualized. The corresponding Russell indices represents U.S. size and style asset classes. The corresponding MSCI World ex USA indices represent international equity asset classes. Emerging markets equity is represented by the MSCI EM IMI Index. The corresponding Bloomberg Total Return indices represent bond asset classes. The S&P Global REIT Index represents global real estate. It is not possible to invest directly in an index. Past performance is no guarantee of future results.

Asset Class Returns

To peel back the onion a bit further on asset class returns, a perhaps lesser-known fact is that there’s no single, absolute definition of each asset class. As Figure 2 shows, while high variability exists across asset classes over time, there’s also high variability within asset classes when we examine different indexes designed to represent each one. In panels A through E of Figure 2, we show calendar year returns for each of the last 15 years and annualized returns over the full period for indexes from well-known providers representing various U.S. equity market segments. The results highlight that these different measures of an asset class can yield meaningfully different returns despite labels that might suggest little difference between them. To demonstrate the variability of returns among indexes within each asset class, we show the difference between the highest and lowest return index in each year and the full period.

Why are Index Returns within an Asset Class So Variable?

The reality is that splitting the market into pieces requires making decisions about how each component will be defined. These decisions can be subjective and vary from one instance to the next. For example, how does one define a small cap company? A “value” company? A “growth” company? Different definitions lead to differences in the securities selected, differences in characteristics, and, as shown, differences in returns. Index holdings are also typically rebalanced (or updated) periodically. In between rebalance dates, company prices and fundamentals are disregarded. Decisions about how often to rebalance an index, such as once a year or quarterly, and on what dates can be arbitrary. Different decisions between index providers can lead to further differences in outcomes.

In many respects, the most important factor driving your investments has nothing to do with market indices. It has to do with your state of mind. To build or preserve sustainable wealth in ever-volatile markets calls for a disciplined outlook based on: (1) adhering to a long-term plan, (2) managing market risks and (3) minimizing the costs involved. We believe this highlights the importance of looking beyond a name and understanding what you own — another sound principle for designing asset allocations. Building broadly diversified portfolios that harness the potential of global markets is a solid starting point.

Still, when it comes to your choices within an allocation, it would be helpful to remember that a name can only tell you so much. It may let you know you’re in the right vicinity but focusing on a more precise location may benefit overall portfolio returns.² Taking a closer look before making an allocation can help avoid unexpected results. When investing, we know we will sometimes be disappointed, but we should try to avoid surprises wherever possible.

Data over the 15-year period from 1/1/2008-12/31/2022. Source: Morningstar. Return periods greater than one year are annualized. It is not possible to invest directly in an index. Past performance is no guarantee of future results.

1. https://tobininvestmentplanning.com/financial-tips/gamestop-the-importance-of-a-diversified-portfolio

2. https://tobininvestmentplanning.com/financial-tips/the-advantage-of-evidence-based-investing

Index Definitions:

CRSP US Large Cap Growth Index: Measures the performance of U.S. large and mid-cap securities (within the largest 85% of the U.S. equity market, based on total market capitalization) and classified as growth securities based on CRSP's multifactor model. CRSP classifies growth securities using the following factors: future long-term growth in earnings per share (EPS), future short-term growth in EPS, 3-year historical growth in EPS, 3- year historical growth in sales per share, current investment-to-assets ratio, and return on assets.

CRSP US Large Cap Value Index: Measures the performance of U.S. large and mid-cap securities (within the largest 85% of the U.S. equity market, based on total market capitalization) and classified as value securities based on CRSP's multifactor model. CRSP classifies value securities using the following factors: book to price, forward earnings to price, historical earnings to price, dividend-to-price ratio and sales-to-price ratio.

CRSP US Small Cap Index: Measures the performance of U.S. small cap companies defined as those within the bottom 2-15% of the U.S. equity market, based on total market capitalization.

CRSP US Small Cap Growth Index: Measures the performance of U.S. securities which are assigned to the MSCI Small Cap Index (within the bottom 2-15% of the U.S. equity market ,based on total market capitalization) and classified as growth securities based on CRSP's multifactor model. CRSP classifies growth securities using the following factors: future long-term growth in earnings per share (EPS), future short-term growth in EPS, 3-year historical growth in EPS, 3-year historical growth in sales per share, current investment-toassets ratio, and return on assets.

CRSP US Small Cap Value Index: Measures the performance of U.S. securities which are assigned to the MSCI Small Cap Index (within the bottom 2-15% of the U.S. equity market ,based on total market capitalization) and classified as value securities by using CRSP's multifactor model. CRSP classifies value securities using the following factors: book to price, forward earnings to price, historical earnings to price, dividend-to-price ratio and sales-to-price ratio.

Morningstar US Large Cap Growth Index: Measures the performance of U.S. large cap companies (within the largest 70% of the U.S. equity market, based on total market capitalization) with an assigned “growth” orientation based on a 10-variable style score that assesses five value and five growth factors.

Morningstar US Large Mid Value Index: Measures the performance of U.S. large and midcap (within the largest 90% of the U.S. equity market, based on total market capitalization) with an assigned “value” orientation based on a 10-variable style score that assesses five value and five growth factors.

Morningstar US Small Cap Index: Measures the performance of U.S. small cap companies defined as companies within the bottom 3-10% of the U.S. equity market, based on total market capitalization.

Morningstar US Small Growth Index: Measures the performance of those Morningstar US Small Index companies (within the bottom 3-10% of the U.S. equity market, based on total market capitalization) with an assigned “growth” orientation based on a 10-variable style score that assesses five value and five growth factors.

Morningstar US Small Value Index: Measures the performance of those Morningstar US Small Index companies (within the bottom 3-10% of the U.S. equity market, based on total market capitalization) with an assigned “value” orientation based on a 10-variable style score that assesses five value and five growth factors.

MSCI USA Growth Index: Measures the performance of U.S. large and mid cap securities exhibiting overall growth style characteristics such as: long-term forward EPS growth rate, short-term forward EPS growth rate, current internal growth rate and long-term historical EPS growth trend and long-term historical sales per share growth trend.

MSCI USA Value Index: Measures the performance of U.S. large- and mid-cap companies exhibiting value style characteristics based on book-to-price, 12-month forward earnings-toprice, and dividend yield.

MSCI USA Small Cap Index: Measures the performance of U.S. small cap companies representing approximately 14% of the U.S equity market, based on total market capitalization.

MSCI USA Small Cap Growth Index: Measures the performance of U.S. small cap companies exhibiting growth style characteristics based on long-term forward EPS growth rate, short-term forward EPS growth rate, current internal growth rate and long-term historical EPS growth trend and long-term historical sales per share growth trend.

MSCI US Small Cap Value Index: Measures the performance of U.S. small cap companies exhibiting value style characteristics based on book-to-price, 12-month forward earnings-to price, and dividend yield.

Russell 1000® Growth Index: Measures the performance of those Russell 1000 Index companies (the 1,000 largest publicly traded U.S. companies, based on total market capitalization) with higher price-to-book ratios and higher forecasted growth values.

Russell 1000® Value Index: Measures the performance of those Russell 1000 Index companies (the 1,000 largest publicly traded U.S. companies, based on total market capitalization) with lower price-to-book ratios and lower forecasted growth values.

Russell 2000® Index: Measures the performance of the 2,000 smallest companies among the 3,000 largest publicly traded U.S. companies, based on total market capitalization.

Russell 2000® Growth Index: Measures the performance of those Russell 2000 Index companies (the 2,000 smallest of the 3,000 largest publicly traded U.S. companies, based on total market capitalization) with higher price-to-book ratios and higher forecasted growth values.

Russell 2000® Value Index: Measures the performance of those Russell 2000 Index companies (the 2,000 smallest of the 3,000 largest publicly traded U.S. companies, based on total market capitalization) with lower price-to-book ratios and lower forecasted growth values.

S&P 500® Growth Index: Measures the performance of those S&P 500 Index companies (500 largest companies in the U.S. equity market based on total market capitalization) with higher value style scores based on three value metrics (book-to-price, earnings-to-price, and sales-to-price).

S&P 500® Value Index: Measures the performance of those S&P 500 Index companies (500 largest companies in the U.S. equity market based on total market capitalization) with higher growth scores based on three metrics (sales growth, the ratio of earnings change to price and momentum).

S&P SmallCap 600® Growth Index: Measures the performance of those S&P SmallCap 600 Index companies (600 companies that represent in total approximately 2.5-3% of the US equity market, based on total market capitalization, with positive earnings for the most recent quarter and the sum of the most recent trailing four quarters) with higher growth scores based on three metrics (sales growth, the ratio of earnings change to price and momentum).

S&P SmallCap 600® Index: Measures the performance of U.S. small cap companies including 600 companies that represent in total approximately 2.5-3% of the US equity market, based on total market capitalization, with positive earnings for the most recent quarter and the sum of the most recent trailing four quarters.

S&P SmallCap 600® Value Index: Measures the performance of those S&P SmallCap 600 Index companies (600 companies that represent in total approximately 2.5-3% of the US equity market, based on total market capitalization, with positive earnings for the most recent quarter and the sum of the most recent trailing four quarters) with higher value style scores based on three value metrics (book-to-price, earnings-to-price, and sales-to-price).

Wilshire US Large Growth Index: Measures the performance of U.S. large cap companies defined as the largest 85% of companies contained in the U.S. equity market, based on total market capitalization, with higher growth style scores based on three growth metrics (forward earnings-to-price, long-term sales growth, and long-term earnings growth).

Wilshire US Large Value Index: Measures the performance of U.S. large cap companies defined as the largest 85% of companies contained in the U.S. equity market, based on total market capitalization, with higher value style scores based on three value metrics (book-toprice, cash flow-to-price, and forward earnings-to-price).

Wilshire US Small Index: Measures the performance of U.S. small cap companies defined as those within the bottom 2-15% of the U.S. equity market, based on total market capitalization.

Wilshire US Small Value Index: Measures the performance of U.S. small cap companies defined as those within the bottom 2-15% of the U.S. equity market, based on total market capitalization, with higher value style scores based on three value metrics (book-to-price, cash flow-to-price, and forward earnings-to-price).

Wilshire US Small Growth Index: Measures the performance of U.S. small cap companies defined as those within the bottom 2-15% of the U.S. equity market, based on total market capitalization, with higher growth style scores based on three growth metrics (forward earnings-to-price, long-term sales growth, and long-term earnings growth).