The Active Component in Passive Investing
2023 was a banner year for growth stocks. However, not all growth indices gave you the same returns.
When it comes to index investing, differences in methodologies influence the classification of growth stocks and these structural nuances shape index behaviour.
We look at the two most popular index for growth stocks, the S&P 500 Growth Index and the Russell 1000 Growth index.
2022 saw both the S&P 500 Growth and Russell 1000 index decline by -29%.
In 2023, growth stocks experienced a recovery.
The S&P 500 Growth index rose by +30.03%
whilst the Russell 1000 Growth index rose by +42.68%.
What explains this large difference in returns when both indices are supposed to capture the returns of growth stocks?
It can be as arbitrary as pure chance of when the index provider rebalances.
S&P 500 Growth index rebalances every December and it uses price momentum as a variable in deciding which companies get accepted into the growth index. Companies that have underperformed in the prior year are unlikely to be classified as growth in the following year. This has resulted in companies, such as Meta, being dropped from the index in 2023 and the addition of energy stocks that have done well in the prior year, such as Chevron and Exxon Mobil.
On the other hand, because the Russell 1000 Growth rebalances in June, many of the Magnificent 7 stocks were not reclassified thus allowing the Russell 1000 to enjoy large positive performance from companies such as Microsoft, Amazon, and Meta.
The main takeaway should not be that the Russell 1000 Growth Index is better than the S&P 500 Growth Index. After all, this year has seen the S&P 500 Growth index do better than the Russell 1000 Growth so far.
Rather, investors must be aware that indices are not created equal and a comparison of 2023 large cap growth performance is a reminder that indices tracking the same market segment can be built differently and deliver significantly different returns. Indices are a man-made construct and there is nothing passive about them. (See how the S&P 500 does not track the 500 largest U.S. companies)
Investors must be aware of the methodologies that go into passive investing such that they are receiving the exact exposure that they want.
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